Credit Sesame Guide to Debt Settlement

In a credit card debt settlement, the creditor agrees to accept less than the full amount owed as full satisfaction of the debt.

Heather Battison, Vice President at TransUnion, explains that “the requirements of each settlement are unique, but typically involve paying a percentage of the debt owed immediately, in exchange for forgiveness of the remaining debt.”

The debtor must enter into a separate agreement with each creditor owed.

Cutting a deal sounds great, right? In truth, if it were that easy to simply pay less than what you owe, the practice would be very common and creditors would lose money every month. Contrary to what radio and TV ads imply, it is not easy to settle your debt for “pennies on the dollar,” and in fact the practice can be costly and risky.

“Debt settlement was one of the worst financial decisions I ever made”


Richard L. was drowning in $100,000 of debt spread over 22 credit cards. His credit score was at the very bottom of the scale. He answered an ad for debt settlement services and eventually settled the debt on 18 of his cards, for a total of $35,000.

Think that sounds like a great outcome? It wasn’t.

“Debt settlement destroyed my credit for a long time, and I didn’t realize the tax implications,” says Richard.

Richard saved money on the debt but had no idea that he was about to get a huge bill from Uncle Sam. Settled debt is often reported as taxable income.

Settled debt is also seriously negative where credit reporting is concerned. It took Richard eight years to climb up to a 700 credit score.

Debt settlement seems like a simple and easy cure for debt maladies, but it’s actually complex and can be costly and damaging.

Here’s what you need to know to decide whether debt settlement is right for you.

Debt settlement eligibility

Creditors are not anxious to enter into debt settlement agreements. Why should they be? They are legally entitled to pursue you for the full amount that you owe.

To be successful, you’ll need to present a strong case for why a portion of your debt should be forgiven. Generally, you’ll need to prove that you suffer from financial hardship. Examples of circumstances that prove hardship:

  • You have missed several payments in a row
  • Large amounts of your debt are in collections
  • You can prove the financial strain is caused by extenuating circumstances, such as medical issues, the loss of a job, or an expensive divorce that wiped out your savings

Debt settlement is a strategy employed by some consumers who face legal action.

“In that case, negotiating a settlement might be a good option, because it may allow the debtor to be able to pay back less than what they owe their creditors and avoid lawsuits or judgments,” says Battison.

Related: Is pay-for-delete legal?

How to settle your debt


There are three main ways you can go about credit card debt settlement.

Debt settlement firm

For a price (that cuts into the savings you gain by settling the debt), debt settlement firms offer experience and expertise, and can streamline the process. They usually deal only with credit card debt that has already gone to a third party for collections. After the firm negotiates the settlements, you make deposits either directly to the firm or into a shared account, and then the firm makes the payments to your debtors on your behalf.

Debt settlement companies charge either an hourly rate or a percentage of the debt.

If you don’t have time to do the legwork yourself, or feel iffy in your negotiation skills, then professional debt settlement might help you. However, some creditors will not work with a debt settlement firm.

This is an industry rife with scams. Don’t base your decision on an ad. Do your homework. You can check to see if any complaints have been filed with the Better Business Bureau and the Consumer Financial Protection Bureau (CFPB) consumer complaint database.

Debt settlement lawyer

A debt settlement lawyer can help you navigate the ins and outs of settling your credit card debt, ensure you’re protected legally, and handle the paperwork properly during the process.

Rates vary: a flat fee, an hourly rate, or a percentage of the debt owed or saved. Some do not charge until the debts are settled.

Do it yourself debt settlement

  • Get organized. Document your activity and conversations every step of the way. Keep records.
  • Research your debts to find out whether you’ll need to negotiate with the original creditor, a law firm or a collection agency.
  • Don’t make partial payments against the debt because some creditors will take that as an indication that you can afford to keep making payments until you pay off the full amount owed.
  • Be prepared to pay a lump sum or to offer a solid payment plan. Keep in mind that some creditors are more willing to negotiate if you are able to pay immediately.
  • Track the percentages each creditor is willing to settle on.

How credit card settlement hurts you


Settling credit card debt can hurt you. Here’s how.

You could be left with more debt than you started with

While you wait for the account to be delinquent enough for the creditor to be willing to negotiate, or while a debt settlement company attempts to negotiate a debt on your behalf, your debt is likely to grow.

“In some cases, a person may try to work with a debt settlement firm to negotiate a deal, but often creditors won’t work with settlement firms,” explains Battison. “So the person could be assessed late fees, penalties, and interest charges if they aren’t making payments while negotiating a deal.”

You might not save money

Fees, penalties and income taxes can negate any savings.

You will demolish your credit if you haven’t already

To build a stronger case, debt settlement companies generally recommend that you stop making payments until the debt is settled. Stopping payments will seriously damage your credit, especially if some of your debt was not yet in arrears.

Furthermore, debt that is reported to the credit bureaus as settled hurts your credit score and could cause future potential creditors to reject your application.

Debt settlement can take longer than you think

“Probably the biggest single misconception about debt settlement is just how the process can take,” explains Charles Phelan, president and founder of, a company that helps people settle debt on their own. “It can easily take 36, 48, or even 60 months.”

Debt settlement does not protect you from legal action

During the debt settlement process, and especially if the process takes a couple of years or longer, you may face lawsuits related to the delinquent accounts, points out Phelan. “It’s necessary to have access to adequate financial resources to complete the settlement project in a more timely fashion, say 12 to 18 months if not less, in order to avoid the escalating legal risk that comes with longer-term programs.”

Rebuilding your credit score is a long journey

If you’re looking at debt settlement as a serious option, your credit may already be poor. If not, it will be when you go down this road. In either case, it’s a few years back to good credit.

Settling on credit card debt tells lenders that you’re unwilling or unable to repay your debts. Serious negative credit data, like collections and accounts closed in arrears, stays on your credit report for seven years past the date of delinquency (so up to seven and one half years).

“Having a lower score can lead to higher interest rates on future loans and credit cards,” says Battison.”That [settled] debt can send ripples throughout your entire financial well-being.”

Know your rights


If you choose to work with a debt settlement professional, know your rights:

  • Fees may never be collected up front, even if you make the first call
  • The debt settlement firm must share basic info such as how their service works, how long they estimate the process to take, and all the fees
  • The shared account you deposit money into for payments must be at an FDIC-insured financial institution
  • The debt settlement firm cannot own or control or be affiliated with the financial institution handling your account, nor exchange referral fees
  • You own all the funds and interest accrued in the account
  • You can withdraw your funds at any time without penalty
  • You get back all the money in the account minus fees earned

Steer clear of companies that say these rules do not apply to them because they are attorneys, are a law firm, or are located outside the U.S. They may be illegally attempting to skirt federal laws.

“One of the most important rights you have as a consumer involves up-front fees,” explains Jay S. Fleischman, an attorney who helps people with credit and debt issues. “A for-profit company selling its services by telephone can’t charge you any fee until it successfully renegotiates, settles, reduces or otherwise changes the terms of at least one of your debts.”

To protect yourself, get a written contract, advises Fleischman. “Get any deal in writing before you make a payment, and make sure you keep up your end of the bargain,” says Fleischman. If you send payment by mail, use a method that provides you with proof of delivery. Keep a copy of the check, proof of delivery, and the settlement letter in case there’s ever a dispute in the future.

Understand your responsibilities


Settlement of a debt is not the end of the story.

Creditors who forgive $600 or more of your debt are required to report the forgiveness to the IRS. You’ll receive a 1099-C “Cancellation of Debt” tax form in the mail. You must include the canceled amount in your gross income—and pay taxes on it—unless you qualify for an exclusion or exception.

“This can cause a lot of problems since the reason for the debt forgiveness is that there is not enough money to pay the debt in the first place,” explains Jeffrey A. Schneider, an enrolled agent and certified tax resolution specialist. “This adds additional debt in the form of taxes on that income. And depending on the amount, the taxes can be significant.”

This comes as a surprise to many debtors.

There are a few exclusions, explains Schneider, including bankruptcy and insolvency. Insolvency is IRS lingo for being flat-out broke. If you can prove that you’re insolvent, you may not have to pay the taxes.

Insolvency really does mean broke. “One item that can cause a person to be solvent when they believe they are not,” says Schneider, “is that they have to include their retirement monies, such as IRAs, 401(k)s, and so forth.”

If you owe taxes and can’t afford to pay them, you will have more work to do:

  • You can set up an installment plan with the IRS
  • You can submit an Offer in Compromise (essentially another negotiated debt settlement, this time with the IRS)
  • You can apply for a Currently Not Collectible (CNC) account, which is a hardship status. You won’t have to pay the taxes for the time being, but the IRS can still charge interest and penalties to your account. Future tax refunds will be applied to the taxes you owe.

Payment options if you owe money to the IRS

Alternatives to debt settlement


One alternative to debt settlement is personal bankruptcy. There are two types of personal bankruptcy: Chapter 7 and Chapter 13.

Chapter 7 bankruptcy is the simpler form of bankruptcy. Most of your unsecured debts, i.e., as credit cards, personal loans and medical debt, will be forgiven. However, not everyone is eligible to file Chapter 7. If you have a job, you will likely be steered to Chapter 13. Likewise, if you are engaged in business and do not want to liquidate, Chapter 7 is not a good option as your assets will be sold. Examples of debtors who are good candidates for Chapter 7 bankruptcy are disabled veterans whose debts were incurred during active duty, and people whose debts come primarily from the operation of a business.

A Chapter 13 bankruptcy reorganizes the debts and puts the debtor on a three- to five-year repayment plan. The amount of debt is capped. Most debtors attempting to discharge personal debt are steered toward Chapter 13.

Credit card debt settlement is best viewed as an alternative to Chapter 13 bankruptcy, points out Charles Phelan of “Too many people are sold debt settlement programs lasting long durations, when they could be completely out of debt for far less money and a shorter period of time with a Chapter 7 bankruptcy (if they are eligible),” says Phelan.

Like any legal process, bankruptcy costs money and takes time.

Related: Getting a mortgage after bankruptcy

Another alternative to debt settlement is a Debt Management Plan, or DMP. In a DMP, an accredited credit counseling agency negotiates the terms of your debt with your creditors, such as forgiveness of fees and penalties, and lower interest rates. Like in a debt settlement, the debtor makes one payment to the fund, and the administrator distributes the money to the creditors. The plan is designed to be completed in five to ten years.

During the DMP, the credit accounts are closed and the debtor may not open any new ones. At the completion of the DMP, the debts are reported as paid-as-agreed, and the recovery to a good credit standing is much quicker.

DMPs usually incur a setup fee and a small monthly maintenance fee, not a percentage of the debt negotiated.

Credit Counseling

The best place to start as you research your best options for breaking free from crushing debt is an accredited credit counselor. Free and low-cost credit counseling is available in all 50 states.

Visit the National Foundation for Credit Counseling (NFCC) to find a credit counselor in your area and get started on the road to financial recovery.

Be sure to sign up for a free membership on Credit Sesame. Here you can get a free credit score, updated monthly, and a free credit report card that evaluates your progress in all the areas that affect your credit score. You’ll feel great when you see your credit health improve, and Credit Sesame offers tips and helpful advice all along the way.

You can trust that we maintain strict editorial integrity in our writing and assessments; however, we receive compensation when you click on links to products from our partners and get approved.
Published August 7, 2017 Updated: August 18, 2017
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