Debt settlement: how it works and what it really costs
Debt settlement means a creditor agrees to accept less than the full balance as payment in full. This usually happens as one lump sum, after the account has gone unpaid for months. It can lower what you repay, but it also brings fees, damage to your credit, possible taxes on the forgiven amount, and no promise that a creditor will agree.
How does debt settlement work?
Most settlements follow the same path, whether you negotiate on your own or a company does it for you. Here is the usual order of events.
- The account falls behind. Creditors rarely offer a discount on an account that is current. Missed payments bring late fees, more interest and collection calls.
- Money gets set aside. With a company, this usually means monthly deposits into a dedicated savings account in your name. On your own, it is savings you keep apart from everyday spending.
- An offer is made. Once enough is saved, you or the company offer a lump sum. By then the account has often been charged off or sold to a collection agency.
- The creditor accepts, refuses or counters. Nothing forces a creditor to settle. Some will, some will not, and some sue for the full balance instead.
- The deal is put in writing, then paid. A written agreement that states the amount, the due date and that the payment settles the account in full protects you if questions come up later.
- The creditor or collector may report the account as settled for less than the full balance, depending on its reporting practices. Canceled debt may be taxable, subject to exclusions and exceptions.
What debt settlement really costs
The headline number is how much of the balance gets forgiven. The real cost includes everything that happens on the way there.
- Settlement fees. Companies usually charge a percentage of the debt you enroll or of the amount they save you. To the best of our knowledge, FTC rules bar companies that sell debt settlement over the phone from collecting fees before they actually settle a debt. The FTC's consumer pages explain the details.
- Interest and late fees while you save. The balance keeps growing during the months you are not paying, so the amount being settled is often bigger than where you started.
- Credit damage. Missed payments, charge offs and "settled" notes stay on your credit report for years. They can make new credit harder or more expensive to get.
- Taxes on forgiven debt. Canceled debt can count as taxable income, though there are exceptions, such as being insolvent. The IRS explains the rules, and a creditor may send you a form reporting the canceled amount.
- Lawsuits. A creditor or collector can sue for the full balance while you are still saving. A court judgment can lead to wage garnishment or a bank levy, depending on your state.
A worked example with the math shown
Example: one credit card with a $10,000 balance. Every number here is made up and rounded so the math is easy to follow. The 50% settlement, 20% fee and 12% tax rate are example rates only, not what any creditor or company will actually offer.
| Step | Math | Amount |
|---|---|---|
| Balance when payments stop | Starting point | $10,000 |
| Interest and late fees added while saving | Assumed for the example | $1,000 |
| Balance at settlement | $10,000 + $1,000 | $11,000 |
| Settlement paid to the creditor | 50% of $11,000 | $5,500 |
| Company fee | 20% of the $10,000 enrolled | $2,000 |
| Forgiven amount | $11,000 minus $5,500 | $5,500 |
| Possible tax on the forgiven amount | 12% of $5,500 | $660 |
| Total cost | $5,500 + $2,000 + $660 | $8,160 |
In this simplified example, the modeled outlay is $8,160, or $1,840 below the original $10,000 balance, before any additional costs and assuming the illustrative tax applies. To reach the $7,500 needed for the settlement and the fee at $250 a month takes 30 months ($7,500 divided by $250), with collection calls and a damaged credit report the whole time. Paying a card in full costs interest too, so I always suggest running the other side of the comparison. You can see what paying the full balance would cost with our credit card payoff calculator.
Doing it yourself or working with a company
Anyone can call a creditor or collector and ask what it would accept. A company does the calling for you in exchange for its fee, and some creditors will not deal with settlement companies at all. Either way, the costs above still apply. Whichever route you look at, these points are worth checking:
- Who owns the debt now. A sold debt is handled by the new owner, not the original creditor.
- How fees are figured and when they are charged. A percentage of enrolled debt and a percentage of savings can produce very different totals.
- How long saving will take. Longer timelines mean more interest, more fees and more time for a lawsuit.
- Every offer in writing. A phone promise is hard to prove later.
- The age of the debt. In some states a payment on an old debt can restart the time limit for a lawsuit. To the best of our knowledge, this varies by state; the CFPB explains how time limits on debt work.
If collectors are already calling, learn your rights when dealing with debt collectors. The CFPB and the FTC both publish plain guides on debt settlement and take complaints.
How settlement compares with other options
Settlement is one of several paths, and each one trades away something different.
- Debt management plan. A nonprofit credit counseling agency sets up one monthly payment, often at lower interest, and you repay the full balance over a set number of years. Here is how a debt management plan works.
- Debt consolidation. You roll several debts into one new loan or card and repay them in full. The differences are laid out in debt consolidation versus debt settlement explained.
- Paying it down on your own. Methods like the snowball or the avalanche put extra money toward one debt at a time with no fees and no credit damage, but only if the budget can carry the payments.
- Bankruptcy. A legal process with its own rules and long credit effects, best discussed with a bankruptcy attorney.
To see these side by side, read all the debt relief options compared.
FAQ
Will debt settlement hurt my credit?
Usually, yes. The missed payments that come before a settlement do the most damage, and the account is then reported as settled for less than the full amount. Both stay on your credit report for years, though their effect fades over time.
Is forgiven debt taxed?
It can be. Canceled debt is often treated as income, with exceptions such as insolvency. The IRS explains the rules, and a tax professional can tell you how they apply to your situation.
Can I be sued while I am saving for a settlement?
Yes. Stopping payments does not stop a creditor or collector from going to court for the full balance. If you get court papers, respond by the deadline; ignoring them can lead to a judgment against you.
Does every creditor agree to settle?
No. Settlement is voluntary. Some creditors accept a lump sum, some insist on full payment, and some refuse to negotiate with settlement companies. No one can promise a result ahead of time.
More on this topic: Debt Help: Where to Start When You Owe Too Much