The Dangers of Debt Settlement

Understand potential downsides of debt settlement

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When you’re in debt, it can feel like you’ll always be financially behind. Among people with debt, three in five (58%) say it negatively affects their ability to achieve long-term financial stability. 

In the search for solutions, you might come across the term debt settlement. This is a process of negotiating debt terms with creditors, often offered as a service by debt settlement companies as an alternative to bankruptcy or as a way to resolve a growing debt

The typical debt settlement client owes more than $25,000 in unsecured debt and is behind on at least one, and, in many cases, most of the seven or more accounts they hold, according to the American Fair Credit Council (AFCC), a national association of debt settlement companies. 

Persuasive advertisements might promise you an easy way out of debt, or a way to simplify your payments. But these services often tack on expensive fees, it’s often not clearly explained what potentially negative effects debt settlement can have on your credit score. 

If you're current on your accounts, or even just one or two months behind (and you want to maintain a healthy credit score), then debt settlement is not for you. 

If you think that debt settlement may be a practical solution to your problems, get the full story before making your decision.

How Debt Settlement Works 

The process starts when you call a debt settlement company and describe your situation:

  1. You provide them with the names of your creditors and the amount you owe. The debt settlement company then gives you an estimate for reducing your debt along with a new, lower monthly consolidated payment. You may also be advised by the settlement company to stop paying your creditors and instead send payments to the debt settler.
  2. The debt settlement company puts your monthly payments into a savings account (this account may charge a maintenance fee). Once the account has grown to a certain amount (this can take months and sometimes up to a year), the debt settlement company calls your creditors and begins negotiating a settlement for each debt. The settlement is an amount lower than your full outstanding balance.
  3. If your creditors agree to a settlement amount, the settlement company pays the creditors and takes a fee for the work of negotiating the settlement. This could be a flat fee or a percentage of the debt (usually at least 15%) that was canceled. 

Avoid debt settlement companies that make guarantees about your debt settlement outcomes or try to charge an upfront fee, which is illegal and a sign of a potential scam.

The Dangers of Debt Settlement

On the surface, debt settlement sounds great. You pay the debt settlement company which, in turn, pays your creditors. In the end, everyone gets paid and you're able to move on with your life. 

But debt settlement can be a long process, and no debt settlement company can guarantee results. There is a chance that you may not see all your debts settled under one of these programs. Borrowers who pursue debt settlement often have trouble keeping up with payments to their settlement account, dropping out before their debts can be settled.

Creditors won't typically settle debts unless they're a few months past due. That means you have to stop paying your accounts and allow them to become past due. The whole process typically takes 26 to 48 months for the debt settlement company and the credit card company to come to terms. During this time, interest and late feeds will make the total grow. Your late payments get reported to the credit bureaus, your credit score drops, and you might begin receiving collection calls.

Regardless of the debt settlement action, those late payments remain on your credit history for up to seven years. Until you start accumulating positive credit activity, you'll have difficulty getting new credit cards and loans. You may even find your credit score interfering with getting a job or a good insurance rate.

The Fallout 

If the debt settlement company successfully settles with your creditors, the delinquent information isn't erased from your credit report. Instead, your account is updated to something that shows you've settled, such as "Charged-Off Settled" or "Paid Charge Off."

A settled status isn't nearly as good for your credit score as a "Paid in Full" account (though it’s still viewed more favorably than delinquent or past-due accounts that remain outstanding). After debt settlement, it may take a few months or even a few years to rebuild your credit and get approved for unsecured credit.

You may owe outstanding taxes on settled debts. The Internal Revenue Service (IRS) treats forgiven debts as income and expects you to pay income taxes on the forgiven amount.

Creditors are required to send you a Form 1099-C for reporting canceled debts and the IRS will expect you to include the debt on your tax return.

Alternative Solutions

As of 2020, Americans were in debt to the tune of $14.56 trillion. And 3.2% of outstanding debt was in some stage of delinquency; of the $462 billion of debt that is delinquent, $349 billion is seriously delinquent, at least 90 days late.

If you're in debt, you're not alone and there are resources that can help you without taking more of your money in the process. 

As a part of your debt management strategy, consider enrolling in consumer credit counseling. The organization will review your debt, credit, and financial situation to develop a custom plan for you to move forward, which may include entering into a debt management plan with your creditors. There's a possibility of reducing your monthly payments, and you'll still be able to pay your balance in full, which will reflect on your credit report. As long as you make your payments on time each month, this process will not directly hurt your credit score, and can provide you with new information and resources.

You can also work out your own payment plan with your creditors. If you've missed one or two payments, ask your creditors if they have a hardship program for customers having financial difficulty. Specifically, use the word "hardship" in your conversation; you may be able to get help in the form of a temporary (six months to a year) reduction in your monthly payment or credit card interest rate.