What Is Debt Settlement and How Does It Work?
Debt settlement can help you get out of debt by reducing the amount you owe, but it’s risky and you likely have other options.
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Debt can be overwhelming, especially if it feels out of control. Maybe you owe more than you think you could ever repay, or your debts are past-due in collections.
Debt settlement may seem like a lifeline in these circumstances. But it’s risky, since it damages your credit, includes costly fees and can take years to complete.
Learn how debt settlement works and compare it with other debt payoff strategies, like credit counseling and debt consolidation.
What is debt settlement?
Debt settlement is the process of negotiating with your creditors and “settling” on a lower amount than you currently owe. It’s usually done with the help of a third party, like a debt settlement company.
Once the creditor accepts the settlement, it can’t continue to hound you for the money, and you don’t have to worry that you could get sued over that particular debt.
Debt settlement gives you a plan for becoming debt-free, which can be a huge relief. But the process can take up to three to four years, and it isn’t always successful.
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How does debt settlement work?
Debt settlement companies negotiate with creditors on your behalf to reduce the amount you owe on unsecured debt like credit cards, medical bills or personal loans. Debt settlement isn’t an option for secured debt, like a mortgage or auto loan.
Settlement offers are only enticing to creditors if it seems like you otherwise won’t pay at all. For that reason, a debt settlement company will advise you to stop making payments on your debts and instead funnel that money into an escrow account (a holding account for the money).
Once you have enough money saved, the settlement company approaches your creditor with the offer to settle. If the creditor accepts, you pay off the debt for the settled amount, and the debt is cleared.
Debt settlement isn’t free. Most companies charge a fee of 15% to 25% of the amount you owe.
Let’s say you owe $10,000, and the debt settlement company charges a fee of 25%. You’ll pay a $2,500 fee to the settlement company once the settlement is complete. This in addition to paying the settled amount to your creditor. A debt settlement company cannot collect this fee until it settles your debt.
Some settlement companies predict an average savings rate of around 20% of the enrolled debt after fees. Using the example above, you’d save about $2,000 once the settlement is complete.
🤓 Nerdy Tip
You may see some companies offering “debt relief.” This is a broad term that refers to multiple strategies for getting out of debt, including debt settlement. It may also refer to debt consolidation or debt management. Before working with any company or lender that offers debt relief, make sure you understand which strategy they’re advertising. Is debt settlement a good idea?
The Consumer Financial Protection Bureau cautions consumers about debt settlement and says working with a third-party settlement company comes with many risks.
- Your credit will take a hit: Settled debts stay on your credit report for seven years, which can make it harder to qualify for affordable credit in the future.
- Penalties and interest accrue: When you stop paying your debts, you’ll face financial penalties like late fees. You may also accrue interest, which adds to the amount you owe.
- You’ll have to pay a fee when a debt settles: Most debt settlement companies charge a percentage of each debt they settle.
- You may pay other fees: Customers may have to pay other fees, like a setup fee to open an escrow account and a monthly fee to maintain the account.
- Forgiven debt may be taxable: The Internal Revenue Service generally see forgiven debt as income , meaning you'll likely be taxed on it. Your creditor may send you a 1099-C cancellation of debt tax notice. This information is supplied to the IRS, and you'll need to report it as "other income" on your tax return.
- There’s no guarantee of success: Not all creditors work with debt settlement companies. Even if they do, they may not accept the settlement offer. Depending on how long settlement takes, the fees and interest that accrue in the meantime may wipe out any potential savings.
Does debt settlement hurt your credit?
Debt settlement can hurt your credit in several ways.
Missed payments: As you stop paying your debts, your creditors will report these missed payments to the credit bureaus after 30 days. Payment history makes up the largest part of your credit score, so any late or missed payments will hurt your score.
Overall debt may increase: As interest accrues on your credit cards, your credit utilization ratio will increase. This ratio measures how much available credit you’re using, and it’s an important factor in calculating your credit score. Typically, the more debt you have, the worse your score.
Collections activity: As your account becomes increasingly overdue, your debt may be turned over to in-house or third-party collections. This debt will be marked as a collections account on your credit report, which can lower your credit score even more. If your score is already low, the effects may be minimal.
Settled accounts are reflected on credit report: Settled accounts show you weren’t able to fully pay back what you owed, which is seen as a negative by future creditors. Settled accounts can stay on your credit report for seven years.
Here’s how to choose a safe debt settlement company
Still, when it comes to debt, paying something may be better than paying nothing at all. If the choice is between not addressing your debt or settling it, debt settlement could be the better option. Here’s how to proceed:
1. Research company reviews and look for accreditations
Before working with any debt settlement company, do your due diligence by researching online reviews. This can include reading posts on Reddit or other forum-style websites, as well as checking with the Better Business Bureau to see if there’s a history of complaints.
Financial websites like NerdWallet also maintain reviews of some of the largest debt settlement companies, including Freedom Debt Relief, National Debt Relief and Accredited Debt Relief.Stick with long-standing companies that have been in business for years and hold outside accreditations, like from the Association for Consumer Debt Relief.
2. Beware of upfront fees or false promises
Stay away from any company that tries to collect an upfront settlement fee or guarantees it can make your debts go away for “pennies on the dollar” or other promised reduction amount, says the CFPB. Debt settlement companies also shouldn’t promise they can stop debt collection calls or lawsuits.
Companies should be upfront about fees and terms of service, how long it will take to settle your debts and how much money you need to save before the company makes a settlement offer, according to the Federal Trade Commission.
3. Say yes to the introductory call
Most debt settlement companies offer a no-obligation, introductory phone call as part of their services.
Take advantage of this free call to get a feel for how a company does business. Ask how much their debt settlement program costs, how it may impact your credit score and the average settlement timeline for customers.
You don’t need to agree to work with the company on this call. Give yourself time to weigh your options.
How to negotiate debt settlement on your own
You can try negotiating a settlement yourself, which saves money on fees and may help you get out of debt faster since you control the timeline.
Gather as much money as you can to make a lump-sum offer. This may mean taking a part-time job, selling valuable belongings or other quick ways to get cash.
Some creditors may be open to a lump-sum offer, which gives them money immediately rather than taking a chance on payments that might not come. Others may have a policy against settling debts.
Alternatives to debt settlement
Debt settlement isn’t the only way to get relief from overwhelming debt. The options below can help you tackle debt and may be a better fit than settlement.
Credit counseling
If you have credit card debt, working with a reputable, nonprofit credit counseling agency is a safer alternative to settlement.
Credit counselors can help you enroll in a debt management plan, which combines your credit card payments into a single payment with lower interest. This gives you a plan to pay off the debt in three to five years.
These plans typically come with a one-time setup fee and a small monthly service fee. Unlike debt settlement, debt management won’t cause lasting damage to your credit score.
Debt consolidation loans
Another option is to take out a debt consolidation loan from an online lender, bank or credit union and use the money from the loan to pay off all your debts at once. You then repay the loan at a fixed rate over a set term, usually two to seven years.
These loans make the most sense if you can qualify for a lower rate than the average rate across your existing debts.
Since these loans help you pay down the debt in full, they won’t leave a derogatory mark on your credit report. If you make all payments on time on your new loan, you can even rebuild your credit by showing a positive payment history.
Bankruptcy
Finally, bankruptcy may be an option, particularly if your debt exceeds 40% of your income and you don’t have a plan to pay it off. Bankruptcy is a legal process that helps eliminate debts for people who can’t pay them back.
Consulting a bankruptcy attorney is usually free, though you’ll pay legal and filing fees if you choose this route.
Similar to debt settlement, bankruptcy should be considered only after you’ve explored other options, since it damages your credit.
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- 1. Consumer Financial Protection Bureau. What Is a Debt Relief Program and How Do I Know if I Should Use One?. Accessed Nov 14, 2025.
- 2. Internal Revenue Service. Canceled debt – Is it taxable or not?. Accessed Nov 14, 2025.
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