Debt Settlement: What to Know and How it Works

December 30, 2019

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There’s nothing worse than being burdened by debt. Fortunately, there are methods that might help reduce the amount you owe.

Debt settlement is the process of negotiating with your creditors to pay less than the full amount you owe. If you find yourself deep in debt and unable to meet your financial obligations, debt settlement, as opposed to bankruptcy, is an option to consider.

Whether working with a debt settlement company or negotiating on your own, the goal of debt settlement is the same: to get creditors to mark a debt as paid in exchange for a partial payment. Most lenders would rather receive a partial payment than no payment at all.

Debt settlement can give you some relief and shorten the road to rebuilding your credit. However, debt settlement will also negatively impact your credit score and credit report, so be sure to understand how it works and the pros and cons before proceeding.

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How Debt Settlement Works

Debt settlement occurs when you pay your creditors a lump sum that is significantly less than what you owe. Settling spiraling debts is sometimes the best solution for creditors, allowing them to recoup at least some of the money you owe them.

That being said, debt settlement has a few major disadvantages:

  1. Not all debt collectors accept offers to settle debts.
  2. If they do, you’ll need to save enough money to make the lump sum payment required, which can take years.
  3. Even if you manage to settle your debt, it’s recorded on your credit report, causing your score to drop.
  4. The forgiven amount of your debt can be considered taxable income, unless you qualify for an exclusion.
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There are a few ways to initiate the debt settlement process. You can write a debt settlement letter to your creditors, specifying the amount you can afford and stating that this is the sum you’ll pay in order for your debt to be settled. Request a response by a certain date to keep the process moving.

While it’s possible to negotiate a settlement yourself, many people choose to use the services of a debt settlement company. Experienced debt settlement professionals do the difficult work of negotiating with your creditors on your behalf. Reputable companies are transparent about the risks involved, the length of time the process could take and how much it all costs.

Six Steps of Debt Settlement

If you feel that debt settlement is right for you, here are the steps to take.

1. Find the right debt settlement company

There are dozens of debt settlement companies out there. Do some research and set up several consultations to ensure you choose a company that’s reputable, trustworthy and affordable.

Find out up front how much it’s going to cost, how long it’s going to take and what the risks are. The company should be transparent and give you this information. If they don’t, beware: they could be scammers.

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2. Begin saving for your debt settlement

Once you’ve started the debt settlement process, you’re typically advised to halt payments with your creditors. Instead, you should pay into the dedicated account set up by the debt settlement company until that account has reached the agreed amount for the lump sum payment.

After about 90 – 180 days, your creditors write off what you owe as bad debt. This is when the debt settlement company approaches your creditors with evidence that you aren’t able to pay, and will start negotiations. During this time, put aside as much money as you can toward your lump sum payment.

3. Accept the settlement offer

Your creditor investigates your case to find out how bad your financial circumstances really are. If they decide that you truly can't pay, they may send a settlement offer.

4. Pay your creditor

Once you’ve approved the offer, you’ll need to make the lump sum payment.

5. Pay the fees

The final step is to pay the company’s fees, which are usually around 15 – 25 percent of the settled debt.

Six Steps of Debt Settlement

Debt settlement is a risky business. Your credit card issuer could simply refuse to accept that you can’t pay your debt. Some lenders won’t deal with debt settlement companies at all. Or, you may get an offer that is more than you can afford.

Types of Eligible Debts

Before deciding whether a settlement is the right choice for you, determine what kind of debt you have. For instance, unsecured debt is often settled, while secured debt almost never is.

Settling unsecured debt

The most popular kind of debt that is settled is unsecured debt—money owed on credit cards, store cards or unsecured loans.

This kind of debt doesn’t have property or other assets secured against it. If you can’t repay the balance and are on course for bankruptcy, the company won’t be able to recover what you owe. If the debt is settled, on the other hand, they recoup at least some of what you owe.

Common types of unsecured debt:

  • Credit cards
  • Medical bills
  • Signature loans
  • Gym memberships
  • Store cards
  • Other unsecured lines of credit

That being said, some types of unsecured debt—such as student loans—are rarely settled by debt settlement companies.

Settling secured debt

Debt secured against property or other assets, such as mortgages and car loans, is not settled often. This is because the creditor can seize your assets instead.

The only circumstances in which secured debt can be settled is if the company has seized your property and you still owe money. In that case, you may need to enter into a settlement with them.

Common types of secured debt:

  • Mortgages
  • Auto loans
  • Government loans
  • Secured personal loans
  • Tax/IRS debt

In some circumstances, whether you can or cannot settle your debt depends on the specific situation. Keep in mind that, usually, you can only settle a debt if you’re experiencing genuine financial hardship.

Pros and Cons of Debt Settlement

There are benefits and risks to pursuing debt settlement—be sure to weigh the pros and cons carefully before proceeding.


Here are some advantages to debt settlement:

  • Debts are reduced, meaning you pay less.
  • Debt settlement provides some mental relief.
  • You won’t be chased by creditors you’ve settled with.
  • You won’t be sued over your settled debt.
  • Debt settlement may allow you to pay off your debt faster.
  • Debt settlement can prevent your account from going to collections or getting charged-off.
  • Debt settlement can have a positive long-term impact on your credit.


Here are some disadvantages to debt settlement:

  • A debt settlement will stay on your credit report for at least seven years.
  • Settling a debt will lower your credit score.
  • Some debt settlement companies are dishonest and you could be scammed.
  • Debt settlement will add a negative mark on your credit report.
  • Debt settlement can be a difficult process without help from a credit counselor.
  • Not all creditors accept debt settlements. By attempting to pursue a debt settlement with a creditor that won’t accept, you may risk a debt collection lawsuit.
  • In most cases, the IRS considers canceled debt as taxable income.

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1099-C Forms: Cancelled Debt as Taxable Income

Debt collectors that accept a debt settlement that is at least $600 less than what is owed are legally required to file a 1099-C form with the IRS and notify you of the form submission.

For example, if you settle an $8,000 debt for $4,000, the IRS will view the $4,000 difference as taxable income. Likewise, when filing your tax returns you must report that portion of forgiven debt as income.

1099-C forms are not uncommon—the IRS Statistics of Income Division estimates that close to four million 1099-C forms will be filed for 2018—but they are often missed. Be aware that failure to report the difference on a debt settlement on your tax returns could result in an audit, penalties and fines.

After you settle your debt, make sure to keep an eye out for a 1099-C form from your debt collector and to include the amount in your tax return.

There are a few cases where you may qualify for an exclusion that reduces the amount you owe on a debt settlement. If you qualify for an exclusion, you have to report the amount and the reason that you qualify to the IRS by filing a 982 form.

Alternatives to Debt Settlement

If you can’t keep up with payments and feel overwhelmed by your credit card debt, there are other options besides debt settlement. Depending on your financial situation, a different avenue could be more beneficial and present less risk.

Here are some alternative options for debt relief:


This is a temporary arrangement for a set number of months. Your credit card company will reduce your interest or monthly payment, or waive your late fees, to give you some “breathing space.” Forbearance works well if you’re confident that you can go back to regular repayments after a few months.

Workout Agreement

A workout agreement is an arrangement with your credit card company to reduce interest rates and waive late fees. A workout agreement is a good option if you can still make monthly payments, but are finding that fees and interest are sending you spiraling into more debt.

Lump-Sum Settlement

The credit card company agrees to accept a reduced payment. A lump sum settlement can help if your financial situation isn’t likely to improve. You’ll need savings, or you’ll need to borrow from a family member or friend to pay the lump sum.

Debt Consolidation

Combine debt from several credit cards into one debt consolidation loan with a fixed rate and a single, monthly payment. Debt consolidation works well for those not too deep in debt. It means you can afford to make payments with a lower interest rate.

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How Much Debt Settlement Affects Your Credit Score

Debt settlement severely impacts your credit score and should be considered as a last resort. A settled account remains on your credit file for up to seven years and could hurt your score by 100 points or more. The amount of impact depends on the type of settlement and how the creditor reports it.

In addition, once you contact your creditors to negotiate your debt, it’s likely that they’ll close your account(s). This will temporarily reduce your credit score as your credit utilization rate increases.

Once you’ve started negotiating your credit card debt, check your credit report on a regular basis to make sure it’s accurate—and contact the credit card company if you find any errors or discrepancies.

How Long Debt Settlement Stays on Your Credit Report

A settled account remains on your credit file typically seven years. Each time a bank or potential lender pulls your credit report, they’ll be able to see the settled debt.

Having this mark on your report lowers your creditworthiness and the likelihood of being accepted for another credit card or loan. After the debt settlement is removed from your report, you can work to rebuild your credit.

Debt Settlement and Credit Repair

While working to settle your debt, you might also find questionable negative items that have been added to your credit report. Fortunately, the law gives you the right to dispute any negative items that are Inaccurate, unsubstantiated, and unverified.

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