Debt Settlement: Cheapest Way to Get Out of Debt?

You might save money and pay off debt faster, but there are some caveats

If you are in debt and cannot pay your bills, is a debt settlement program the cheapest way out of debt? You might draw that conclusion from a recent report by the American Fair Credit Council (AFCC), an industry association of companies operating in the debt settlement industry.

Key takeaways from the group’s 2021 report include that:

  • Debt settlement provided, on average, $2.64 in consumer savings for each $1 fee assessed.
  • Nearly all offered settlements, more than 98%, resulted in a decrease of the client’s debt that was greater than the accompanying fees.

Still, is debt settlement the cheapest way to emerge from debt? Let’s take a closer look.

Key Takeaways

  • Debt settlement involves offering a lump-sum payment to a creditor in exchange for a portion of your debt being forgiven.
  • You can attempt to settle debts on your own or hire a debt settlement company to assist you.
  • Typical debt settlement offers range from 10% to 50% of the amount you owe.
  • Creditors are under no obligation to accept an offer and reduce your debt, even if you are working with a reputable debt settlement company.
What Is Debt Settlement?

Investopedia / Mira Norian

What Is Debt Settlement?

Debt settlement, also called debt relief or debt adjustment, is the process of resolving outstanding debt for far less than the amount you owe by promising the lender a substantial lump-sum payment. Depending on the situation, debt settlement offers might range from 10% to 50% of what you owe. The creditor then has to decide whether to accept.

“Debt settlement can save consumers money by allowing them to resolve their debts for less than the full balance,” notes Gerri Detweiler, co-author of the e-book Debt Collection Answers: How to Use Debt Collection Laws to Protect Your Rights. “It can be a way out of debt for some individuals who can’t afford to pay back the full amount they owe,” she adds.

Consumers can try to settle their debts on their own or hire a debt settlement company to do it for them. In the latter case, you’ll pay the firm a fee that’s calculated as a percentage of your enrolled debt. Enrolled debt is the amount of debt you have when you enter the program. By law, the company can’t charge this fee until it has settled your debt. Fees average 20% to 25%.

Debt settlement may also entail tax costs. The Internal Revenue Service (IRS) generally considers forgiven debt to be taxable income. If, however, you can demonstrate to the IRS that you are insolvent, you will not have to pay tax on your discharged debt. The IRS will consider you to be insolvent if your total liabilities exceed your total assets.

According to AFCC data put together by Freedom Debt Relief, one of the country’s largest debt negotiators, debt settlement is by far the cheapest option compared to credit counseling or making minimum monthly payments, as the infographic below shows.

Infographic with information about the savings provided by debt settlement
Freedom Debt Relief; data provided by the American Fair Credit Council.

However, whether debt settlement will be the least expensive option for you depends on the specifics of your situation.

Debt settlement will most likely have a negative impact on your credit score.

Debt Settlement Strategies and Risks

Ironically, consumers who enroll in a debt settlement program because they can’t manage their debt burdens—but who have still been making payments, even sporadic ones—have less negotiating power than those who have made no payments. So, the first step is often to stop making payments altogether.

“Credit scores can suffer during the debt settlement process, particularly at the beginning,” says Sean Fox, co-president of Freedom Debt Relief. “As the consumer begins to make payments on settled debt, credit scores typically will recover over time.”

Becoming delinquent on debt and settling the debt for less than you owe can have a severe impact on your credit score—likely sending it into the mid-500s, which is considered poor. The higher your score before you fall behind, the larger the drop. Late payments may remain on your credit report for up to seven years.

Making no payments also means accumulating late fees and interest, which add to your balance and will make it harder to pay off your debt if you can’t settle. Consumers can expect harassing debt collection phone calls once they become delinquent. Creditors might also decide to sue consumers for debts above $5,000—debts that are worth their trouble, in other words—which can result in wage garnishment.

“The more money you have available to settle, the sooner you can resolve the debt. The longer your debt goes unpaid, the greater the risk of being sued,” Detweiler says.

There are no guarantees that after you’ve incurred this damage, the lender will agree to a settlement or settle the debt for as little as you had hoped. For example, Chase will not work with debt settlement firms. It will only work directly with consumers or nonprofit, licensed credit counseling agencies that help consumers. The Consumer Financial Protection Bureau (CFPB) cautions that the accumulated penalties and fees on unsettled debts could cancel out any savings that the debt settlement company achieves for you, especially if it doesn’t settle all or most of your debts.

7 Years

The length of time that a debt settlement stays on your report from its original delinquency date.


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Debt Settlement vs. Bankruptcy

When the process works as intended, debt settlement can benefit everyone involved. Consumers get out of debt and save money, debt settlement firms earn money for providing a valuable service, and creditors receive more than they would if the consumer stopped paying altogether or entered Chapter 7 bankruptcy. Chapter 7 bankruptcy involves liquidating the debtor’s nonexempt assets and using the proceeds to repay creditors. Exempt assets vary by state but often include household and personal possessions, a certain amount of home equity, retirement accounts, and a vehicle.

Compared to debt settlement, Detweiler says, “if a consumer is eligible for Chapter 7 bankruptcy, it may be a faster option. It is a legal process that can stop collection calls and lawsuits. Debt settlement doesn’t offer those guarantees.”

Still, she adds, “there may be a variety of reasons why Chapter 7 may not be a good option. A consumer may have to surrender property they may feel they need to keep. Or they may not want their financial troubles to be a matter of public record.”

Individuals could also find their job options limited if they declare bankruptcy, as some employers check on applicants’ credit histories as part of the hiring process.

Another problem that many indebted consumers face is not being able to afford a bankruptcy attorney. And in some cases, the court may reject their filing.

“Many consumers cannot qualify for bankruptcy protection,” Fox says. “In contrast, debt settlement is available to any consumer who can demonstrate a financial hardship, such as a job loss, reduction in hours worked, medical expense, a death in the family, divorce, etc., and is struggling to make progress in paying down their debt.”

Chapter 7 bankruptcy can be over and done with after three to six months, vs. what could be years for debt settlement. It can be less stressful and may allow your credit score to recover faster, though bankruptcy will remain on your credit reports for up to 10 years.

Many debt settlement programs require you to deposit a certain amount of money into a specified savings account every month for 36 months or longer. Before you sign up for a program, be sure that you can afford to make those deposits for the entire length of the debt settlement program.

Debt Settlement vs. Minimum Monthly Payments

Making minimum monthly payments on high-interest debt is not a good option for consumers who want to save money. It can take years—even decades—depending on how much debt you have and what the interest rate is. Interest typically compounds every day on your entire balance, and with minimum payments, you make little progress in paying your balance down each month.

Consistently making minimum monthly payments and forking over tons of interest might make you highly profitable to your creditors. A solid payment history is good for your credit score, but spending more than you have to on interest is a very expensive way to boost your credit score. A good credit score won’t pay for your retirement; money in the bank will.

Furthermore, if the amount of available credit you’ve used is high relative to your credit line, that will hurt your credit score and potentially negate the effect of your consistent, timely payments.

Consumers who consistently make just the minimum monthly payment on high-interest credit card debt can end up paying more in interest than the original principal.

Debt Settlement vs. Credit Counseling

Credit counseling is a free or inexpensive service provided by some nonprofits and government agencies. Interestingly, these services are often partly funded by credit card companies. By enrolling in a debt management plan with a credit counseling agency, you may receive an interest rate reduction on your balances and a waiver of penalty fees.

Those concessions may or may not be sufficient to help you pay down your debt considerably faster, and you may or may not be able to afford the new required monthly payments. In addition, you might not qualify for an interest rate reduction, even if you have a significant financial hardship.

However, because you won’t have to default on your debt, your credit score may suffer less. Also, credit counseling may offer additional financial assistance that can help you avoid similar problems in the future, such as budgeting advice and financial counseling, as well as referrals to other low-cost services and assistance programs. 

So, how do you know which option to choose if you don’t want to file for bankruptcy? It’s usually better to pursue credit counseling before you consider contracting a debt settlement company. Credit counselors can help you determine the best course of action. That may include debt settlement, but in a way that benefits you. On the other hand, a debt settlement company may be more interested in your fees than the health of your credit.

Credit counseling and debt consolidation loans are appropriate for consumers with more modest financial stress on the spectrum of financial hardship. At the same time, debt settlement and bankruptcy can help those who have more significant financial stress. It is very dependent on the individual situation.

The Federal Trade Commission website has helpful information about how to choose a credit counselor. The National Foundation for Credit Counseling is another good resource.

What percentage of a debt is considered in a settlement?

According to a report from the Center for Responsible Lending, on average, debts are settled for 48% of the outstanding balance. However, the report also found that the balance increases 20% because of charges that the creditor might impose during negotiation for debt settlement.

How do you negotiate a credit card debt settlement yourself?

The best way to negotiate a credit card debt settlement yourself is to call your card issuers and ask them if you can be put on a plan to settle your debts. Some creditors will work with you, depending on your situation.

How do you find a good debt settlement company?

If you are looking for a good debt settlement company, you could:

  • Ask your friends and family if they have any recommendations
  • Ask your financial advisor, if you have one
  • Look for online reviews

Investopedia publishes a periodically updated list of the best debt relief companies. Also, the Federal Trade Commission (FTC) offers information about credit counseling and debt settlement companies.

What is a debt settlement scam?

Unfortunately, debt settlement scams are not uncommon. These charlatans will typically ask you to pay a high amount for their services but do little or nothing on your behalf. They may say they have ways to “fix” or remove adverse information from your credit report, which is not possible unless the information is erroneous. Worse, a debt settlement scam can put you even deeper in debt if the company claims to have contacted your creditors and leads you to believe your debt is paid off.

Always look up debt settlement companies online via the Better Business Bureau or your state attorney general’s office before signing up with one.

How do you repair your credit after debt settlement?

Debt settlement stays on your credit report for seven years, starting on the first date of your delinquency. To repair your credit after a settlement, it is important to not go over your credit limits, pay your bills on time, and make sure your credit utilization ratio stays relatively low. If you do all that, then your credit score will improve over time.

The Bottom Line

Debt settlement can sometimes be the least expensive way to get out of debt. It depends in part on how much you owe, and there are other factors to consider, such as how much time it takes and how stressful you might find it compared with the alternatives. It’s important to think through the pros and cons of debt settlement before you choose it—and to make sure that you’re dealing with a reputable company if you do.

The best approach is to research all options. “If you are struggling with debt, talk with a credit counseling agency, a debt settlement expert, and a bankruptcy attorney, so you understand your various options and make an informed decision,” Detweiler says.

Article Sources
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  1. American Fair Credit Council. “Options for Consumers in Crisis: An Economic Analysis of the Debt Settlement Industry: Fourth Edition—February 16, 2021.”

  2. Nolo. “Negotiating with Collectors on Unsecured Debts.”

  3. Gerri Detweiler. “Debt Collection Answers.”

  4. Federal Trade Commission, Consumer Advice. “How to Get Out of Debt: Debt Settlement.”

  5. Internal Revenue Service. “Publication 4681: Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals),” Pages 3 and 5.

  6. American Fair Credit Council. “Facts About Debt Settlement.”

  7. Consumer Financial Protection Bureau. “How Long Does Negative Information Remain on My Credit Report?

  8. Consumer Financial Protection Bureau. “What Are Debt Settlement/Debt Relief Services and Should I Use Them?

  9. Experian. “How Long Do Settled Accounts Stay on a Credit Report?

  10. United States Courts. “Chapter 7—Bankruptcy Basics.”

  11. Federal Trade Commission, Consumer Advice, via Internet Archive. “Debt Relief or Bankruptcy?

  12. Federal Trade Commission, Consumer Advice. “Choosing a Credit Counselor.”

  13. Center for Responsible Lending. “State of Lending: Debt Settlement.”

  14. Federal Trade Commission, Consumer Advice. “How to Get Out of Debt,” select “Credit Counseling” and/or “Debt Settlement.”

  15. Federal Trade Commission. “Debt Relief and Credit Repair Scams.”

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