What Is Debt Settlement and How Does It Work?

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What is debt settlement?
How does debt settlement work?
Is debt settlement a good idea?
- Your credit will take a hit: Delinquent accounts and 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 making payments on your debts, you’ll likely face financial penalties like late fees. You may also accrue interest, increasing the overall 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, based on that debt’s balance when you enrolled in the program. Some charge a percentage of the debt eliminated by the settlement.
- You may pay other fees: In addition to the settlement fee, customers may have to pay other fees, such as a setup fee to open the dedicated escrow account and a monthly fee to maintain the account.
- Forgiven debt may be taxable: The Internal Revenue Service generally regards forgiven debt as income
, meaning you'll likely be taxed on it. Depending on the debt, your creditor may send you a 1099-C cancellation of debt tax notice. This information will be supplied to the IRS, and you'll need to report it as "other income" on your tax return. Even if you don’t receive a 1099-C, you may still be legally required to report canceled debt as income. - There’s no guarantee of success: Debt settlement doesn’t always work. Not all creditors work with debt settlement companies, and 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.
Summary: The risks of debt settlement |
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Does debt settlement hurt your credit?
- 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 in relation to your available credit, the worse your credit 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, though it may vary based on how much your credit score has already been affected.
- 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
1. Research company reviews and look for accreditations
2. Beware of upfront fees or false promises
3. Say yes to the introductory call
How to negotiate debt settlement on your own
Alternatives to debt settlement
Credit counseling
Debt consolidation loans
Bankruptcy
Article sources
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- 4. Consumer Financial Protection Bureau. What Is a Debt Relief Program and How Do I Know if I Should Use One?. Accessed Jan 16, 2025.
- 5. Experian and Oliver Wyman. Financial Inclusion and Access to Credit. Accessed Jan 23, 2025.
- 6. Internal Revenue Service. Canceled debt – Is it taxable or not?. Accessed Apr 1, 2025.
- 7. National Credit Union Administration. Credit Union and Bank Rates 2024 Q4. Accessed May 23, 2025.
- 8. Federal Reserve. Military Lending Act. Accessed May 2, 2025.
- 9. Consumer Financial Protection Bureau. Consumer Use of Buy Now, Pay Later and Other Unsecured Debt. Accessed Jan 24, 2025.
- 10. Center for Responsible Lending. Unsafe Harbor: The Persistent Harms of High-Cost Installment Loans. Accessed May 2, 2025.
- 11. Angi.com. How Much Does It Cost to Make My Home Accessible?. Accessed Nov 12, 2024.
- 12. Consumer Financial Protection Bureau. What are the costs and fees for a payday loan?. Accessed Jun 6, 2025.
- 13. Internal Revenue Service. Home energy tax credits. Accessed Mar 6, 2024.
- 14. Center for Responsible Lending. Unsafe Harbor: The Persistent Harms of High-Cost Lending. Accessed Jun 6, 2025.
- 15. Solar Energy Industries Association. Solar Power Purchase Agreements. Accessed Mar 7, 2024.
- 9. Consumer Financial Protection Bureau. Consumer Use of Buy Now, Pay Later and Other Unsecured Debt. Accessed Jan 27, 2025.
- 17. SolarReviews.com. Homes with Solar Sell for 6.8% More [2024 Zillow Data Study]. Accessed Dec 10, 2024.
- 18. Internal Revenue Service. Retirement Topics - Plan Loans. Accessed Apr 8, 2025.
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