Everything You Need to Know About Debt Settlement and the Risks Involved

Chang Fu
Apr 24, 2020

What is debt settlement?

Debt settlement is the process of negotiating with your creditors - including banks, credit unions, and other lenders - to pay less than the full amount you owe on your loan. Paying less than the full amount you owe to your creditors sounds amazing and seems like a no-brainer, but there are risks as well. You can try to “settle” your outstanding debt yourself or through a debt settlement firm. In either case, you’ll need a good understanding of how debt settlement works, what the pros and cons of debt settlement are, and how it weighs up versus the other options such as debt management or declaring bankruptcy.

How does debt settlement work?

The debt settlement process can vary slightly depending on whether you choose to do it yourself or have a third-party company like Freedom Debt Relief or National Debt Relief get a debt settlement for you. At a high level, concepts can be similar.

First, are you a good candidate for debt settlement?  Many creditors won’t consider debt settlement unless you are at least 90 days delinquent. According to a Nerdwallet article, 5 months delinquent and not making monthly debt payments could be the right time to consider negotiating for a debt settlement. This is also around the time your lender might sell your debt to third-party debt collectors.

Have you considered other options like bankruptcy and credit counseling? Debt settlement isn’t always the right option for everyone. It can lead to an additional decrease of your credit score, more debt and fees, and additional financial burdens.

Are you a good negotiator? Confidence can be key to getting a good debt settlement result with your bank or financial institution. If you believe you can settle your debt for a small proportion of the total amount you borrowed, you probably can. Each lender is different but knowing what each side wants and being a savvy negotiator will help you get to the finish line.

Below are the steps in a normal debt settlement process, whether you do it yourself or have a third party company help:

  1. Understand your situation, including how much money you have, how hard you can bargain, how long you’re willing to be delinquent, etc.
  2. Know the terms of your loan and exactly what you want in the negotiation. For example, what % of the debt do you want to settle for and how do you want it reported on your credit history
  3. Negotiate with your lender - this may be through phone calls, emails, or in-person
  4. Finalize the deal you’ve negotiated in writing - that allows both parties to hold themselves accountable to the debt settlement deal
  5. Commit and pay your debt settlement as agreed - if you’re late or don’t hold your end of the bargain, all your work could be in vain and you might be back to square one

Debt settlement strategy

You’re looking to negotiate two main things - payment and credit.

Payment. Settling for paying 40-50% of the amount you originally owe can be feasible depending on the lender and depending on how well you negotiate your debt settlement. You’ll also want to nail down the revised timing and term of those payments. Hint: Don’t be too optimistic - give yourself plenty of time and room to make your revised payments.

Credit. Although your credit report is likely a mess after the many delinquent marks against you (see earlier question about whether you’re a good candidate for debt settlement), you’ll want to slightly redeem yourself by getting your creditor to mark the settled debt account as “Paid as agreed” rather than “Settled” or “Paid Settled” on your credit report.

Below are some tips while negotiating:

  1. Be patient. Take multiple calls and communications if you need to. If someone on the front lines isn’t as receptive as you expect, ask to talk to a manager or just call in again in a few hours or the next day.
  2. Be polite. It helps to be reminded that the folks you’re working with are still people and have their own emotions. Treat them well and you might find them more willing to help you get the positive result you want. Treat them badly and you might find your hopes of settling your debt dashed immediately.
  3. Be savvy. Know how much you can realistically pay and aim lower than that so you can have room to maneuver and negotiate. If you can’t realistically pay an amount, you should look at alternatives such as bankruptcy.
  4. Be positive. Give yourself some credit. Whether you’re successful or not, you’ve taken the time to understand your situation and put your best foot forward. That deserves a pat on the back by itself.

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DIY debt settlement vs debt settlement company

So should you negotiate a debt settlement arrangement yourself or use a debt settlement company to negotiate on your behalf? The primary differences are time, effort, and money.

Time. Debt settlement companies can take longer than doing it yourself. Completing a debt settlement plan with a debt settlement company may take as long as 3 years whereas doing it yourself can be as short as 6 months. If you’re willing to take the credit score hit, you can go delinquent immediately and look to negotiate a settlement 3 to 6 months after that. Who knows what your economic and personal situation looks like 2 years from now?

Money. Debt settlement companies usually charge a 20-25% fee on the enrolled debt once you agree to a settlement and start making your revised payments or make a lump sum payment. In addition, you may have set up and monthly retainer fees related to the debt settlement company as well. That means that the majority of the savings from your debt settlement may go to the debt settlement company! For example, if you are able to reduce your debt outstanding to 50% and your total fees paid to the debt settlement company is 30% of your outstanding, your net savings is only around 20%.

Effort. Unfortunately, negotiating a debt settlement yourself takes effort. You need to understand your financial situation, plan ahead, and negotiate well with your creditors. Putting in the time and effort yourself can pay huge dividends. If you’re able to reduce your debt 50% without having to pay a debt settlement company, that’s huge!

Does debt settlement affect your credit?

Part of the debt settlement strategy is missing your normal payments to your lender and helping the lender understand that you can’t make the monthly payments by going delinquent. Because you aren’t making your debt payments as agreed upon with your lender, your credit score will be negatively impacted.

But how much? A FICO credit score is a common way banks and many lenders look at your credit history and understand how likely repayment is. A FICO score is calculated using many factors but one of the most important factors in calculating a FICO score is repayment history. MyFICO ran through some examples and missing payments by over 90 days can have an impact anywhere from 30-40 points to as much as 150 points.

Because there is such high variability in how much your credit score could be negatively impacted, plan accordingly. Know that your credit score will drop significantly, plan for the worst, and do everything you need to do w/ a higher credit score before you start your debt settlement. That means applying for the credit card you need, getting lower rates on mortgages and car loans, and debt consolidation programs (if it makes sense).

You’re in a better position to access credit before you start your debt settlement than after. Once your debt settlement is done, settled debt stays on your report for up to 7 years and it may take years to rebuild your credit.

Eligible debts for debt settlement

Most unsecured debt is eligible for debt settlement, including:

  • Unsecured credit cards
  • Unsecured personal loans
  • Payday loans and most installment loans
  • Medical bills and utility bills
  • Private student loans (note that public student loans are usually not eligible)

Why isn’t secured debt like a mortgage or car loan eligible for debt settlement? Secured debt involves collateral in which the financial institution can repossess the collateral used for the loan such as the home or automobile. Therefore, in most cases, the collateral has significant value and it makes more sense for the lender to sell the repossessed collateral than to negotiate a debt settlement with you.

Tax consequences of debt settlement

Unfortunately, you won’t escape the taxman and the IRS with a debt settlement. According to debt.org, 4 million people received an IRS form 1099-C and had at least $600 in debt forgiven in 2018.

The Internal Revenue Service (IRS) treats the debt forgiven through debt settlement the same way it treats your weekly paycheck - as taxable income. You should receive a 1099-C tax form from your lender at the end of the year for debt forgiven. Remind your lender if you don’t receive one because you’ll still be responsible for reporting it on your year-end taxes.

For example - suppose you have $20,000 in outstanding credit card debt and you’re able to negotiate that down to $10,000 through debt settlement. That $10,000 in debt forgiven goes on Line 21 of your tax return and will be counted as income according to the IRS.

Are there exceptions? No, there aren’t - in the past through laws passed by Congress, there has been exceptions. The Mortgage and Debt Relief Forgiveness Act passed originally in 2007 allowed for exclusions related to mortgage debt but 2017 was the last year it applied.

Pros and cons of debt settlement

Here are the pros and cons of debt settlement. Remember, each person’s situation is different so understanding your personal finances, credit score, and economic situation will help you determine the best way to go.


  • It can lower your debt amount significantly, leaving you with 25-65% of your original debt amount
  • It may help you avoid bankruptcy
  • Having a concrete debt settlement plan may get creditors off your back and reduce stress


  • Bankruptcy and clearing all your debts may be a better option for you depending on your circumstance
  • Your lender may not want to negotiate and you could end up with additional fees and even more debt
  • Your credit score may drop significantly
  • Using a 3rd party debt settlement company can be costly and your net savings may be small

Debt settlement vs debt management vs debt consolidation

Debt-related terms can be confusing. It’s important to understand the differences between debt settlement, debt management, and debt consolidation.

Debt settlement is the topic of this article and is also known as debt arbitration, debt negotiation, or credit settlement. It’s a way of debt reduction in which you and your lender/creditor agree on a reduced balance on your debt that will be regarded as paid in full.

Debt management is most commonly associated with a debt management plan (DMP) in which a credit counselor or agency works with a lender/creditor on your behalf to lower payments and interest rates. Your debt amount is NOT lowered through debt management. Your credit counseling agency will also work with you to set a budget based on regular income and expenditures.

Debt consolidation involves re-financing higher cost debt into a new loan with a lower payment. For example, if you have multiple credit cards with high-interest rates, you might consolidate into a personal loan with a lower interest rate and combined monthly payments. Debt consolidation may make sense if you have a good credit score and you need to reduce your monthly payments. It will NOT lower your outstanding debt amount.

Alternatives to debt settlement

So, what can you do if debt settlement isn’t right for you? Or if debt settlement is too much of a risk for common alternatives:

  1. Credit counseling and debt management plan (DMP) - Through a DMP, credit counseling agencies can help you lower your interest and payments and get your budget in order. However, expect to pay a monthly fee as well as an initial set up fee. Nerdwallet goes through a few non-profit credit counseling agencies that can help.
  2. Balance transfers and debt consolidation - If you have an OK or good credit score, usually above 700, balance transfers and debt consolidation may be an option for you. You can transfer the balance of a credit card or debt in one place to another - of course, that assumes you can get a new credit card or take on another unsecured line of credit in your current financial situation. With debt consolidation, you can roll all your high-interest debt into one payment, usually a personal loan with lower interest.
  3. File bankruptcy. Filing Chapter 7 or Chapter 13 bankruptcy might be the best option for you. NOLO has a comparison of Chapter 7 vs Chapter 13. Chapter 7 is a type of liquidation bankruptcy that wipes out most unsecured debt without a need to repay any of them. There are income and perhaps other requirements to qualify. Chapter 13 bankruptcy is a reorganization bankruptcy where some or all of your debt may still need to be paid back but it allows for higher incomes and you may be able to keep some of your property.
  4. Talk to your creditor, especially if that’s Possible Finance - At Possible, we believe in fair access to credit and helping our customers improve their financial health. If you are in a tough spot, just reach out to us and we want to help you. We’ll work with you if you can’t pay back your debt and you can read more about our policies if you cannot pay back our loans.

Final verdict

Debt settlement is a controversial process of getting your debt amount reduced with your creditor (bank or financial institution) and isn’t right for everyone. However, people who negotiate the debt settlement themselves and are working with a willing lender can reduce their debt by more than 50% and improve their financial situation significantly. Debt settlement comes with risks though, including a lower credit score, more costs, and fees, plus it may not even work! Evaluate your situation carefully and determine whether debt settlement is the right solution for you.

Chang Fu

Chang is an avid writer, among other things, at Possible. He grew up loving reading and writing, creating his own poems and even a book he's now hidden in an old closet, unpublished. His financial experience at a large bank along with his passion for technology to help underserved communities inspires him to write for Possible.

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