What Is Debt Settlement and Is It a Good Idea?

Debt settlement is one option you may consider when credit card balances or other bills start to pile up. In a nutshell, debt settlement involves asking your creditors to accept less than what’s owed on an outstanding balance.

Settling debts has both pros and cons, including potentially negative impacts to your credit score. Here’s more on what debt settlement is and how debt settlement works.

What is Debt Settlement?

Debt settlement essentially means reaching an agreement with one or more creditors about how an outstanding debt is to be repaid. Specifically, the creditor agrees to allow you to settle your account for less than what’s owed.

This is typically something creditors will only consider when a debt is delinquent. If you’re current on your credit card bill, for example, the credit card company has no incentive to settle your balance because they’ll assume you can afford to keep making payments. But if you’re several months behind, they may be motivated to accept less than what’s owed so your account isn’t a total loss.

RELATED:

How Debt Settlement Works

There are two ways you can approach debt settlement:

Take the DIY route and negotiate settled debts on your own
Hire a third-party debt settlement company to negotiate on your behalf

If you’re settling debts on your own, the process might begin with you reaching out to your creditor debt collector to make a settlement offer. For example, if you owe $5,000 in credit card debt you might offer $3,500 to settle it.

At this point, the creditor might make a counter-offer. Once you agree on a settlement amount, you’ll pay the creditor, either in a lump-sum or several installments. The creditor will then forgive the remaining amount owed and mark your account as paid as agreed or settled on your credit report.

If you’re hiring a debt settlement or debt relief company, they’ll handle negotiating an offer for you. Once there’s an agreement, you’d pay the funds to the debt settlement company. The debt settlement company would then distribute the money to the creditor.

The biggest difference between DIY debt settlement and hiring a debt relief company is cost. When you hire a debt settlement company they can charge fees for their services. The trade-off is that letting someone else settle debts for you can save you time and energy.

RELATED:

How Much Does Debt Settlement Affect Your Credit Score?

Debt settlement assumes that you have one or more credit accounts past due. For FICO credit scoring, payment history carries the most weight in score calculations. So if you’ve fallen behind on payments to one or more debts, your score has likely already taken a significant hit.

Negative items, including late payments and collection accounts, can remain on your credit reports for up to seven years. Having a debt show up as settled on your credit report can hurt your score, though the number of points you may lose can depend on where your score was before the settlement was finalized.

RELATED:

Is Debt Settlement a Good Idea?

Debt settlement has both pros and cons and it’s important to weigh both when deciding if it’s the right option for managing your financial obligations. Here’s a quick look at how they compare:

Debt settlement pros

Clear outstanding debts for less than what’s owed
Stop debt collection calls and letters
DIY debt settlement allows you to avoid paying fees
Avoid a bankruptcy filing

Debt settlement cons

You’ll need cash to make the settlement payment
Your credit scores will suffer
Forgiven debt may be taxable
Debt negotiation companies can charge steep fees

You may also run into a snag if your creditors are unwilling to agree to a debt settlement. That leaves you open to a debt collection lawsuit if you’re unable to find a solution for repaying what’s owed.

Consider a Debt Consolidation Loan Instead

While debt settlement can provide financial relief, the risks may outweigh the potential benefits. If you simply need to make your debt more manageable so you can pay it off, a debt consolidation loan might be the better option.

Using a personal loan to consolidate debt can help you streamline your monthly payments. Instead of keeping up with multiple credit card bills, for instance, you’d make just one payment to your loan.

Depending on your credit score you may be able to get a personal loan at a lower interest rate than what you were paying on the debts you consolidated. And making on-time payments to a debt consolidation loan could help boost your credit score over time.

If you’re interested in getting a personal loan to consolidate debt, check your credit report and scores first to get an idea of what loan terms you’re likely to qualify for. Then take time to compare lenders to find the best fit for APR, fees and repayment terms, based on your creditworthiness.

How to Deal with Debt

What to know about paying off debt and getting your finances back on track

Rebecca Lake

Rebecca Lake is a freelance writer specializing in personal finance, credit and debt. She’s a contributor to U.S. News and World Report, Forbes Advisor and The Balance and her work has appeared online at CreditCards.com, MyBankTracker, Money-Rates.com and dozens of other top publications.