Debt settlement is the process of negotiating with a lender to achieve more favorable terms. Sometimes, this can include adjustments to interest rates or repayment schedules.

More commonly, debt settlement usually involves a borrower making a single large payment in exchange for the discharge of their entire outstanding balance. Lenders are sometimes willing to pursue this option because they may lose more money in the event that a borrower defaults in the future, or files for bankruptcy.

The Negotiation Process

An insolvent borrower has more leverage than a borrower still able to meet minimum payments. For this reason, most debt settlement programs request that the borrower stop making payments after enrolling.

This can cause a dramatic drop in a borrower’s credit score; often into the “poor” credit range. Borrowers may be unable to obtain new loans during this period.

Furthermore, some creditors may launch lawsuits against delinquent or non-paying borrowers. Expenses for legal defense can leave borrowers with more debt, or having to file bankruptcy. In extreme cases, the court may also order that debtors may have to have assets sold or wages garnished (more on this later) in order to pay off debt. A study reviewed by the FTC found that approximately 6-10% of debt settlement program enrollees were sued. [1]

After a settlement agreement is reached, a borrower’s credit score gradually begins to improve, as their outstanding debt and credit utilization declines.

From 2011-2020, the average reduction in debt resulting from debt settlement was 32% for each account of unsecured debt after accounting for fees. [2]

Fees & Taxes

Many companies offer to negotiate on your behalf for a commission, as a percentage of your enrolled debt, the balance in which the debt is being settled. Typically, this ranges from 20-25% of the enrolled debt.

Suppose a debt settlement company charged a 20% fee. In our earlier example where a borrower sought $10,000 relief for credit card debt, they would have to pay $2,000 to the debt settlement company, reducing their total return from debt settlement from $5,000 to $3,000.

Unless a borrower is considered “insolvent” by the IRS, a status applied when a borrower has more liabilities (debt) than assets, money gained from debt forgiveness is taxed as income.

Nevertheless, debt settlement is usually successful for borrowers, with 98% of debt settlement participants being offered a debt settlement greater than fees. [3]

Debt Settlement Scams

In addition to legitimate companies, debt settlement frauds that charge high fees and offer no returns are fairly common. These scams often attract customers by falsely claiming that new debt relief legislation or government programs have been introduced. Debt settlers are not legally allowed to charge any fees until a settlement is reached; settlers that charge up-front fees are not legitimate. Another warning sign lies in companies claiming to offer implausibly high settlement ratios, or any other “too good to be true” promises. To avoid such scams, borrowers can confirm the reputation of a debt settler with the Better Business Bureau.

Pros & Cons

Pros

Effective Results: 98% of participants reduced debt by an average of 32% after accounting for fees. On average, debt settlement saves more money than credit counseling.

Cons

Cash Required - For settlers to agree to forgive debt, settlers often require a large amount of cash upfront.
Damage to Credit Scores - Debt settlements and delinquent payments can remain on credit reports for up to 7 years.
High Fees - Debt settlers typically charge a fee of 20-25% of enrolled debt.
Tax Liability - Debt forgiven is usually counted as taxable income.
Lawsuits - Some 7-10% of debt settlement participants are faced with lawsuits, which can result in extensive legal fees or court orders.