Debt settlement refers to the process of negotiating with your lender to settle your debt for less than what you owe. If the lender accepts your settlement offer, you’ll resolve the debt by making a lump sum payment for the amount your lender accepts, and the rest of your balance will be waived or simply forgiven.

This may be a good option when you have maxed out credit cards or are behind on payments by several months. However, it’s important to consider debt settlement pros and cons and consider other debt-relief options to choose a payoff strategy that makes sense for your financial situation.

Pros of Debt Settlement

Debt settlement is often considered by borrowers that have limited options to pay off what they owe. For these people, there are many benefits worth considering.

1. Pay Off Debts Faster

Debt settlement can reduce the amount you owe, which makes it possible for you to pay off what’s left over faster. Compared to other options like debt management plans, settlement is much faster. Most settlement programs can be completed within two to four years.

2. Avoid Bankruptcy

With debt settlement, your lenders will get at least some minimum amount of money. With Chapter 7 bankruptcy, they typically end up not receiving anything at all, so they’re often more willing to negotiate a settlement rather than demand the full balance and end up with nothing. The impact of credit score on debt settlement vs. bankruptcy is also something you should consider.

A bankruptcy will stay on your credit report for seven to ten years, depending on whether you’re filing for Chapter 7 or Chapter 13 bankruptcy. Compared to that, a settlement will have a much less negative impact on your finances and your credit.

3. Stop Collection Calls

Once you reach an agreement with your lenders, you won’t receive debt collector calls. Collection calls can be a major source of stress for most people, so this is an important benefit if you’re feeling harassed and overwhelmed.  

4. Save Money

One of the major benefits of debt settlement is that you’ll be able to save a considerable amount of money. Experienced debt negotiators can often help you save as much as 50% of your debt before fees. For example, if you owe $10,000 on your credit cards, you may be able to resolve the debt by making a lump sum payment of $5,000.

Cons of Debt Settlement

While there are several advantages of debt settlement, there are also a few disadvantages that you should be aware of.

1. Lenders May Not Negotiate

You’ll only be able to settle your debt if your lenders agree to it. If your lender refuses to accept your settlement offer, you’ll need to come up with an alternative repayment plan. Typically, lenders and credit card companies will only accept settlement offers when they feel there is a better-than-average chance they won’t be able to recover any money from you.

2. Late Fees

You’ll typically need to stop making payments on your debt during the settlement process. Instead of making continued payments to your lender, you’ll divert those payments toward accumulating money in a separate bank account for the lump sum payment of your negotiated settlement amount. This is because lenders aren’t likely to accept your settlement offer if you’ve only missed one or two payments. However, once you stop making payments, you’ll start accumulating late fees each month you skip a payment.

3. Credit Score Impact

You’ll see an almost immediate impact on your credit score once you stop making payments on your account. Once you settle the debt, your lender may report it as a “partial payment” to the credit bureaus or mark it as “settled for less than full amount” or something like that. This can also hurt your credit score. One option is to ask the lender to report the debt as “paid in full” as a part of your negotiations.

4. Tax Consequences

Any amount that your lender forgives through a settlement is known as canceled debt and is considered reportable as taxable income by the IRS. Depending on your income and tax filing status, you may need to pay federal and possibly state income taxes on this amount.

Factors To Consider Before You Opt for Debt Settlement

Will debt settlement work for you? That depends on your unique situation. Here are a few scenarios where a settlement may be a good solution.

Scenario 1: Let’s say you have maxed out multiple credit cards and carry a total unsecured debt of $25,000. You don’t have enough resources to pay off the full amount. It may make sense to settle the debt instead of trying to pay it off through a DMP or debt consolidation, especially if you can’t qualify for a good interest rate on your debt consolidation loan.

Scenario 2: Another scenario where it makes sense to settle your debt is when you have high credit card balances, are paying a lot in interest charges, are struggling to make minimum payments, and your credit score is already declining. A settlement will lower your credit score further, but it is a better alternative because you won’t be able to qualify for a good rate on a consolidation loan with your current credit score.

Here are a few factors to consider before you decide if debt settlement is right for you:

  • Amount of debt: Debt settlement usually makes sense when you have over $10,000 in unsecured debt (e.g. credit cards, line(s) of credit, and/or medical bills). You may want to consider other options if you owe less than that.
  • Credit score: If your credit score is declining or is already so low that you can’t qualify for other debt-relief options like consolidation, debt settlement may be a better idea.
  • Ability to save: To settle your account, you’ll need to make a lump sum payment to your lender. You must be able to consistently put aside money each month to save this lump sum.

Alternatives to Debt Settlement

After weighing debt settlement pros and cons, if you think that it’s not a good option for you, you may find that there are other reasonable alternatives available.

  • Credit counseling: Counselors at nonprofit credit counseling services can review your finances, provide personal finance education, help you make a budget, and create a personalized payment plan to help you pay off your debts.
  • Debt management plans: Credit counselors can enroll you in a debt management plan through which you can consolidate your debts, benefit from lower interest rates, and waive late fees.
  • Debt consolidation: If you have a good credit score and stable income, you can secure a debt consolidation loan or a 0% balance transfer card. Debt repayment may be easier with a single payment each month.
  • Bankruptcy: Bankruptcy may be a last resort option if you have a lot of unsecured debt and almost no assets. Consult a bankruptcy attorney to determine if bankruptcy is right for you.

Is Debt Settlement the Right Option for You?

If you have a lot of personal loans, medical bills, or credit card debt with maxed-out cards and are finding it difficult to keep up with minimum payments, debt settlement can help you settle your debts for less than you owe.

Carefully consider debt settlement pros and cons before you decide to enroll in a program. Here are the next steps to follow if you’re considering this option:

  • Carefully consider if you’ll be able to make consistent monthly payments to save for your lump sum settlement payment.
  • Research debt settlement companies in your area and verify that the one you choose is accredited and trustworthy. Check to see if there are any complaints against the company with the Better Business Bureau or the Consumer Financial Protection Bureau (CFPB).
  • Get a free consultation with a debt relief company to learn about all your debt relief options and determine whether debt settlement makes sense for you.