What is Debt Settlement and How Does it Work?

7 Min Read | Last updated: November 30, 2023

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Debt settlement helps you reduce debt by paying a fraction of your total balance. Learn more about how it works, its impact on your credit score, and its risks.

At-A-Glance

  • Debt settlement is a way for consumers to reduce debt by paying a fraction of their total balance.
  • Consumers can use a debt settlement company, or negotiate directly with their creditor.
  • Debt settlement will almost always have a negative impact on your credit score.

The number of Americans having a hard time keeping up with debt payments is increasing, according to a 2023 report by the Federal Reserve Bank of New York.1 Moreover, the trend appears to be growing faster for those in their 20s: the same report found that nearly 9% of credit card balances for people aged 18-29 were seriously delinquent (90+ days) as of the first quarter of 2023.1

 

This trend can be particularly troubling for young people, since credit score damage from delinquencies can make it harder to take out mortgages or other loans in the future. But there are many ways young Americans can start managing their debt. One option is debt settlement—though it comes with risks.

What is Debt Settlement?

Debt settlement is a debt reduction method in which the credit issuer allows a person to pay off their debt for less than the original balance owed, typically in the form of a lump-sum.2,3 How much a creditor will settle for depends on several factors, including your overall balance and financial situation.

 

But a creditor won’t likely accept a debt settlement if they believe you could pay the full amount—otherwise, why would they settle for less? In other words, a creditor is only likely to approve a debt settlement proposal if they fear you may not be able to pay the balance at all.3,4

Using a ‘Professional’ Debt Settlement Company vs Doing it Yourself

A debt settlement or debt relief company will attempt to negotiate with your creditors to accept a lump-sum payment for less than your original balance. To build that lump sum, you’ll probably have to make monthly deposits into a savings account held by the debt settlement company. Meanwhile, they’ll likely advise you to stop paying your creditors to improve the chance of your settlement being approved—a high-risk move that could have negative consequences.

 

Debt settlement companies might seem like the easy way out, but experts say they’re not always a good idea. According to the U.S. Consumer Financial Protection Bureau (CFPB), debt settlement programs are notorious for offering unsound financial advice, being expensive, and risky.4 What’s more, the Federal Trade Commission (FTC) says many consumers drop out of debt settlement programs without settling their debts.5 For more information about debt settlement companies, see “Are Debt Relief Programs Too Good to Be True?”

 

Arranging a do-it-yourself debt settlement with a creditor might take a little bit more time and effort, but it’s also less risky and you won’t have to pay for someone else’s services—and that savings can make a big difference if you’re deep in debt. But still, there’s no guarantee that your debt settlement will be approved. If all else fails, you can try to arrange a modified payment plan to reduce your monthly payments.

How to Negotiate Debt Settlement Yourself

Here are the steps experts recommend to negotiate a debt settlement on yourself:

  1. Learn about and understand your debt. First, figure out if you’re a good candidate—do you have delinquent payments that you’re truly unable to pay off, or can you manage to pay off your debts in full? Paying in full is always best since it will leave your credit in better standing (more on that later), but it isn’t always possible.5 If your finances are deep in the red, debt settlement might be a viable option.
  2. Create a realistic repayment or settlement proposal. Create a budget to determine how much you can pay. Although debts are typically settled as a percentage of the total balance owed, it can help to have a good idea of a concrete dollar amount. It can also help to keep track of your debts so you can better explain your situation. But beware: if the amount forgiven is $600 or more, you’ll have to pay taxes on it as if it were income—which, in a sense, it is.4,5,6
  3. Present your proposal to your creditor and negotiate. Negotiation will likely require persistence and persuasion. It might even take more than one call.
  4. Finalize the deal and commit! If you and your creditor come to an agreement, get the terms of the settlement in writing. This way, you can hold each other accountable. Then, all that’s left to do is commit, and follow through.

Debt Settlement Can Hurt Your Credit Score

Whether you do it yourself or use a debt settlement company, debt settlement can negatively impact your credit score. Exactly how much depends on factors like the current condition of your credit and the size of the debts being settled.5,6

 

When the debt is settled, your creditor will likely send an update to your credit report to show a status of “Settled.” While experts say a “Settled” status is better than seeing “Unpaid” on your credit report, any payment status other than “Paid in Full” can hurt your credit. What’s more, debt settlement will stay on your credit report for seven years.5,6

Given the Risks, is Debt Settlement a Bad Idea?

If debt settlement companies can be risky, and even DIY debt settlement can hurt your credit score, you may be wondering if debt settlement is even worth it. Like all things finance, it depends! On one hand, taking a debt settlement is better than having unpaid debts. But it can also have negative consequences. In the end, you have to weigh the situation on your own and figure out if debt settlement is a better alternative to debt consolidation, enrolling in a debt management program, or filing for bankruptcy.

The Takeaway

Debt settlement means your creditor will allow you to settle your debt for less than your outstanding balance. Unfortunately, it’s not as easy—or safe—as it sounds. Negotiating with your creditor can take a lot of time and effort, whereas debt settlement companies can be risky and expensive. What’s more, debt settlement will likely damage your credit score. Regardless, debt settlement might still be the right debt-reduction method depending on your financial situation.

Headshot of Megan Doyle

Megan Doyle is a business technology writer and researcher whose work focuses on financial services and cross-cultural diversity and inclusion.
 
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.

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