U.S. Markets close in 3 hrs 59 mins

Why Debt Settlement May Not Be the Solution to Your Debt Problem

Sarah Cunnane
Why Debt Settlement May Not Be the Solution to Your Debt Problem

When you're falling behind on your bills and don't think you can ever catch up, debt settlement — also known as debt relief — can seem like an appealing alternative to filing for bankruptcy.

You hire a company to negotiate with your creditors, to see if they'll settle your debt. That is, allow you to repay an amount you can afford — and let you off the hook for the rest.

That may sound very appealing, but debt settlement can be expensive and risky. Here's what you need to know.

How debt settlement works

RAGMA IMAGES / Shutterstock
Debt settlement might erase part of your debt.

If you've missed multiple debt payments and are receiving weekly calls from collection agencies, debt settlement may allow you to get a handle on your debt relatively quickly.

Creditors would rather receive a smaller repayment amount than nothing at all, so they're often open to working with debt settlement companies. If you have a debt of $10,000, a $2,000 payment plan should sound better to the lender than $0.

Debt settlement can relieve some of the burden from unsecured debt — like credit cards — but not secured debts, such as your mortgage or your auto loan. A creditor would prefer to just repossess the car than give you a break on your loan.

The balances on federal student loans can't be reduced through debt settlement either. For that, you'll have to turn to government programs for eliminating some of that debt, though the process can take many years.

When you work with a debt settlement company, it will likely be tell to stop making payments on your debt and instead put that money into a savings account. There, you build up a lump sum that the company will offer to a creditor, to make that debt go away.

Why debt settlement can be risky

Andrey_Popov / Shutterstock
Your creditors may not want to work with the settlement company.

The risks when you pursue debt settlement can include these:

  1. Your creditors may not want to talk with the debt settlement company. Some banks won't work with debt settlement firms, so be sure to do your research on whether the process is even a possibility for you.

  2. You could fall even deeper in debt. Suspending payments won't stop the clock on your debt. You'll face late fees, you could get slapped with a steep penalty interest rate, and your phone may ring even more often with calls from bill collectors.

  3. Your credit will take a hit. When you stop paying on any credit account, it will be considered delinquent. The delinquency will haunt your credit reports for seven years.

Why debt settlement can be costly

Yellow Cat / Shutterstock
Debt settlement comes with fees.

Debt settlement can take a heavy financial toll. Here are a few of the ways things can get expensive:

  1. There are fees to be paid. Debt settlement companies are businesses out to make money. Once a debt is settled, you might be charged a percentage of the settlement amount — or a percentage of the original debt.

  2. You can find yourself owing taxes. Any debt that's forgiven through debt settlement is considered taxable income. In other words, if you owed $10,000 and were able to pay just $6,000, you earned the other $4,000 in the eyes of the IRS.

  3. You might find a "bad apple." The Federal Trade Commission recently announced that thousands of consumers were bilked out of $23 million by a scam that made phony promises of relief from student loan debt and charged illegal upfront fees.

The U.S. Consumer Financial Protection Bureau's database indicates the agency has received more than 330 complaints about debt settlement companies since 2014. In many of the complaints, consumers claim they were defrauded or charged stiff fees.

Alternatives to debt settlement

GaudiLab / Shutterstock
You might be able to negotiate a lower debt payment on your own.

If you want to avoid bankruptcy, you have other options besides turning to debt settlement. You might:

  • Call your credit card issuers and other creditors, to try negotiating down your debts on your own. You may find the banks will be willing to accept a lower payment amount if it'll keep you from defaulting or declaring bankruptcy.
  • Look into debt consolidation, to make your debt more manageable. Rolling your debt into a 0% balance transfer credit card or other lower-interest consolidation loan will cut the cost of your debt and take some stress off.
  • Find a credit counseling service in your area. These nonprofits can help you work out an affordable plan to dump your debt — and budget your way out of financial trouble.

Join the MoneyWise mailing list! You’ll get the latest financial tips and news, straight to your inbox.