Debt Settlement Pros and Cons: What’s the Risk vs. Reward?

According to, total household debt surpassed $16 trillion in the second quarter of 2022. Meanwhile, mortgages, auto loans and credit card balances increased by $312 billion. Balances now stand $2 trillion higher than at the end of 2019, before the start of the COVID-19 pandemic. Chances are, you are one of those with ballooning debt searching for solutions.

Several debt relief options exist, but borrowers must understand the pros and cons of each before deciding how to proceed. Whether working with a debt settlement company, a credit counselor or attempting DIY debt consolidation, you must understand the risks and the rewards of each. Here we will break down what you need to know about debt settlement.

Pro tip: There is no one-size-fits-all approach when it comes to debt repayment. Each of us has a unique financial situation. It’s important that you research your options before deciding which method will work best for you.

At a glance: Pros and cons of debt settlement

Lower monthly paymentCreditors may not agree to settle
You’ll pay off debts fasterYou’ll pay some interest and fees from missed payments in the early days
Long-term savingsYou’ll have to be thick-skinned
Better option than bankruptcyMany debt settlement programs will only accept your debts total $10,000 or more
It could keep you out of courtDoes not include secured debts
Fewer worries about moneyNot all unsecured debts can be included
It will stop debt collection calls
It will eventually be better for your credit score
Better for your mental health

READ MORE: Debt settlement — how to get your debt under control now

How debt settlement works

Debt settlement involves negotiating with creditors or debt collectors for a settlement amount that’s typically lower than what you currently owe. According to the American Association for Debt Resolution, debt settlement saves consumers $2.64 for every $1 in fees paid.

Unsecured debts such as medical bills, credit card debt, personal loans, payday loans and some private student loans are eligible for settlement.

Borrowers with secured debts like mortgages and car loans have fewer options because they stand to lose an asset if they don’t repay the debt.

Debt settlement can be handled in three ways:

In any type of debt settlement effort, a borrower generally stops making payments on all enrolled debts. During this time, the borrower instead makes monthly deposits into a separate savings account until they have accrued enough cash to negotiate a settlement agreement with the creditor or debt collector. Once a deal has been reached, whether it’s a single lump-sum payment or a series of monthly payments, funds that have been collected in that separate account will be used to pay the settlement.

READ MORE: Debt settlement fees

Why it works: Most lenders would rather accept less than the total debt owed than risk receiving no payment at all.

READ MORE:How debt settlement works


A few key benefits exist for borrowers who successfully complete a debt settlement program.

  • Long-term savings: You’ll end up paying less than you owe. Debt settlement companies negotiate on your behalf to persuade lenders to forgive part of the debt. Most creditors will agree to settle for a payment that falls between 30% to 50% of the loan’s original value.
  • Fewer worries about money: One of the biggest advantages of debt settlement is escaping the debt cycle. By entering a debt settlement program, you are actively taking charge of your personal finances and working toward lowering your total amount of debt. When you’re finished, your financial situation will be improved and you’ll have a fresh start without feeling burdened by debt.
  • Pay off debts faster: Because you ultimately end up paying a lower amount, you will solve your problems faster and feel less pressure when it’s time to pay the bills.
  • It could keep you out of court: Payment plans can ward off a court summons, and you won’t be at risk of having your wages garnished.
  • It could be the cheapest option: Debt settlement could cost less overall compared to credit counseling, debt management or making the minimum monthly payments. If you settle debt, it can be paid off in half of the time it would if you were to continue making minimum monthly payments. Some debt settlement companies can do it in as little as 12 months but, on average, it will take about 48 months.
  • It may be a better option than bankruptcy: You can avoid a bankruptcy filing, which will hurt your credit for up to ten years. Debt settlement, or debt negotiation, involves wiping out debt by paying a portion of what you owe, either in a lump sum or fixed monthly payments. In doing so, you avoid going to the bankruptcy court. Filing bankruptcy should always be viewed as a last resort. Bankruptcy will do significant damage to your credit report and can cause difficulties getting home loans and even certain jobs in the future.
  • Stop debt collectors from calling: If you settle with your creditors, this could stop harassing phone calls once your debt is paid. However, debt settlement is not designed to stop the collectors from calling.
  • Positive impact on mental health: One of the negative impacts of having more debt than you can handle is dealing with your mental health. Once you have started to pay off your debts, this can give you a mental boost and inspire you to make better financial choices in the future.

READ MORE: 5 steps to pay off credit card debt over $10,000


Debt settlement also has a few disadvantages, but most of these are actually relatively minor.

  • You’ll have to be thick-skinned: Creditors will continue to attempt to collect the outstanding debt and could get threatening. Because you will be asked to stop making payments, you will likely receive harassing calls and debt collectors may even try to contact your friends or family. However, debt collection is regulated by federal law, and you have rights through the Fair Debt Collection Practices Act, which is enforced by the Federal Trade Commission (FTC.)
  • Creditors could refuse to settle: There are no guarantees that your creditors will agree to settle your debts. No matter what some debt settlement companies try to tell you, creditors are not legally obligated to negotiate settlements. But they usually will because, with a settlement, they’ll recover more funds than they’d get through other collection methods, including a collections agency or bankruptcy. One of the benefits of using a debt settlement company is that the company will know which creditors flat-out refuse to settle debts. If your creditor refuses to settle, you may have to opt for a debt management plan instead. With a debt management plan, you can negotiate for a lower interest rate but still pay the total amount owed.
  • You may pay more in interest and fees: Mounting interest and late fees will accrue when you stop making minimum monthly payments. Since you will have to stop making payments, fees and penalties will continue to compound. If you do not complete your debt settlement plan, you could end up paying even more in the long run. Debt settlement programs can easily take two to four years to complete, so make sure you are dedicated to paying your settlement in full. If you don’t finish the program, you could end up owing more than you did initially. ‘
  • Does not include secured debts: A secured debt is a type of loan where the borrower uses an asset — like a house or car — as collateral to secure repayment. Because the debt is secured by this asset, the lender has no incentive to settle debts that you may be unable to repay. The lender can simply take possession of the collateral and sell it to recover the outstanding balance of the debt.
  • Not all unsecured debts can be included: Certain unsecured debts are ineligible for debt settlement. This includes loans backed by the federal government, alimony, child support, auto repair bills and utility bills.

READ MORE: Debt settlement qualifications

Your credit score will initially fall but will rebound

Debt settlement will hurt your credit score in the short term, primarily because of late payments, charge-offs and a high debt utilization ratio. As you complete the debt settlement program, your credit score will start to rebound as you establish a pattern of on-time payments and close some of your accounts. It will be significantly less damaging to your credit score than a bankruptcy filing.

Debt settlement will impact your credit score differently based on your score before settlement. Borrowers with the highest credit scores will see the largest negative impact.

For example, here is the estimated impact based on the FICO scoring model:

  • A credit score of 730 could drop to 535, almost 200 points
  • A credit score of 630 could drop to 545, less than 100 points
  • A credit score of 505 could drop to 470, a 35-point drop

As you can see, someone with a 630-credit score could settle a debt and end up with a higher credit score than a borrower whose score started at 730.

How it affects your credit score depends on a few other factors, including your credit utilization ratio, the number of open accounts you have and your debt-to-income ratio.

Though the details of your debt forgiveness plan will not show up in your credit report, when employers pull your credit, they will see that the debt has been marked “settled” or “paid in full.” A “settled” notation won’t affect your credit score but could be a red flag to potential landlords or employers if they suspect an inability to repay your financial obligations. To help avoid this, some creditors are even willing to negotiate how your settlement will be reported to the credit bureaus.

READ MORE: How will debt settlement impact your credit score?

Eventually, your credit will increase because settling debts improves your credit utilization ratio, one of the strongest influences on your credit score. The quicker you repay your debt, the sooner your credit scores will rise. Ultimately, it’s more about what you do after the program is complete that matters.

READ MORE: 15 ways to build credit without a credit card

Do you have to pay taxes on forgiven debt? 

It’s complicated. Settling debt does have a few tax implications. Forgiven debts over $600 may be counted as income on your taxes, so it’s possible that you’ll get 1099 forms from your creditors. The IRS could consider the forgiven debt as taxable income, and you may have to pay them for the total debt that has been settled.

If a lender forgives some or all of your debt, that forgiven amount may be considered taxable income. For example, if you owed $10,000 on a credit card and the lender agreed to accept $5,000 as a settlement, the forgiven $5,000 may be considered taxable income. However, there are some exceptions to this rule, particularly if the settlement was due to financial insolvency or hardship. Also, if you settle a debt for less than the total amount owed, you may be able to deduct the amount of interest that you would have paid on the total amount from your taxable income.

It is always a good idea to consult with a tax professional to understand your specific tax situation and any potential tax implications of debt settlement.

Debt settlement scams: What you need to know

Legitimate debt settlement companies will charge you a fee. Usually, it will be a percentage of the total debt that’s settled. Doing your homework before selecting a company to work with is important. Make sure the representatives are knowledgeable, can answer your questions and that you feel comfortable working with them. Some settlement companies even include access to legal help if the case runs into complications. Those are the legitimate ones.

Pro tip: It’s essential that you’re comfortable with the company you choose. You must discuss sensitive financial matters with the people you choose, so if someone makes you feel uncomfortable or awkward in your initial consultation, trust your gut and choose someone else.

Some debt settlement companies may have hidden fees and attempt to exploit struggling customers. Investigate the company and read any online company reviews. If someone seems sketchy or unwilling to answer your questions, find another company to work with. Check the Better Business Bureau and follow the safeguards the Consumer Financial Protection Bureau recommends.

The most obvious sign of a debt relief scam is if the person or company offers to help eliminate your debt by paying them an upfront fee. If this happens, cease all contact and file a complaint with the Consumer Financial Protection Bureau (CFPB), the Federal Trade Commission (FTC) and your state attorney general’s office.

Pro tip: You should be looking for a company with no upfront fees, a free initial consultation, positive consumer reviews and a proven track record of results. Ask the company if it provides legal representation if necessary.

READ MORE: Debt settlement qualifications

For an extra layer of protection, verify that the debt relief company you chose is licensed in your state and confirm that it has the appropriate credentials.

Unfortunately, scams are prevalent. Watch out for these signs:

Other debt relief options

  • A debt consolidation loan can pay off debt and knock multiple accounts down to one monthly payment with a lower interest rate.
  • A balance transfer credit card will allow you to transfer a chunk of debt and pay no interest during the promotional period.
  • Visit a credit counseling agency (look for a nonprofit one) and get set up with a debt management plan. Though the consultation is free, a debt management plan will usually cost between $25 to $55 per month. Ultimately, debt management plans will almost certainly be more expensive than debt settlement.

READ MORE: Debt relief programs

The bottom line 

Debt settlement can eliminate your unsecured debts by paying a fraction of what you owe.

Working with a legitimate debt settlement company will help you navigate the process and save you from trying to negotiate your own deal. Though your credit score may initially fall, getting out of debt and starting the path to a clear financial future can be worth it.


How much should you offer when trying to settle debt on your own?

Make an offer between 15% and 50% of your total debt (start at the lower end but be prepared to increase your offer). Once your debt goes to collections, the people attempting to collect are typically instructed to take less money. The company you owe money to has already sold your debt to a creditor for pennies on the dollar, which means they want to make a profit. Try negotiating as much off as possible since your credit score will take a hit either way.

How do I remove a settled account from my credit report?

Removing a recently settled account from your credit report is impossible. The Fair Credit Reporting Act requires creditors to report information accurately. If the negative information in your report is correct, you can do nothing except wait up to seven years, when it should automatically be removed.
After seven years, if the settlement still appears on your credit report, you should file a dispute with the credit reporting company (Experian, Equifax, or Transunion). In writing, submit what is wrong and why, and include your dated settlement agreement.

Is debt settlement worth the effort?

The short answer is yes. Debt settlement is worth it if all of your debt is with a single creditor, and you can offer a lump sum to settle your debt. A settlement offer may be the right option if you carry a high credit card balance or deficit. Credit card debt settlement can provide, on average, $2.64 in savings for every $1 you pay in fees. Some debt management companies can settle the debt in as little as 12 months but guarantee settlement within 48 months. On average, debts are settled at 48% of the outstanding balance. But remember that balances could increase up to 20% due to fees from the credit card company during settlement negotiations. You need to understand if this makes sense as a debt relief option for your financial situation.

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