Debt Settlement: What is It and How It Works

Learn how to make effective settlement offers to get out of debt for less than you owe.

If you’ve been struggling with debt, then you’ve likely heard about debt settlement. What is it, and is it good for your finances? Let’s explore this option for debt relief, and what you should consider before choosing debt settlement.

Thinking about fixing Debt

What is debt settlement?

Debt settlement is a relief option that allows you to settle a debt for less than the full amount owed. You make an offer to the creditor, lender or collection company for a percentage of what you owe. After negotiation, you reach a settlement agreement where the company agrees to discharge the remaining balance on the account in return for the partial payment.

This type of debt relief is most commonly seen with debts that are already delinquent due to nonpayment. This can include:

  • Charged-off credit cards
  • Collection accounts, including things like unpaid utilities, mobile plans and medical bills
  • Private student loans
  • Back taxes owed to the IRS

If you only have one debt to settle, then you may be able to take care of the negotiation yourself. However, if you have multiple debts to pay off, you might need a debt settlement program.

What is a debt settlement program?

A settlement program is a professionally assisted type of debt settlement. You work with a company that negotiates settlements on your behalf. First, the company helps you generate the funds for making settlement offers. Then once you have enough money to make an effective offer, the professionals negotiate for you.

A debt settlement program is generally the right solution if you have multiple debts that you need to settle at once. This typically only applies to settlement for credit card debt and collection accounts. Student loan settlement and tax debt settlement are unique; we’ll describe these more below.

If you’re tired of struggling to pay back everything you owe, debt settlement may be the right solution to get out of debt fast.

See If You Qualify

How does it work?

Debt settlement negotiation can work a little differently, depending on how you do it and who initiates the contact. There are four basic ways that debt settlement can work.

You can:

  1. Contact a debt settlement company to set up a debt settlement program and negotiate on your behalf
  2. Negotiate debt settlement on your own
  3. Work with a state-licensed debt settlement attorney
  4. Respond to a debt settlement letter from a collector

How it works if you use a debt settlement program

This is how debt settlement works when you hire a debt settlement company to handle the negotiation for you.

  1. First, you must have funds available to make a settlement offer
    • Since most people don’t have the funds needed just sitting around in savings, you must generate the funds you need.
    • In most cases, the company will create an account where you set aside funds.
    • Each month you set aside a small amount of money into the account.
  2. Next, the debt negotiation team go to each creditor, lender or collector to make a settlement offer.
  3. There will be some back and forth to reach a final settlement agreement.
  4. Once the agreement is in place, you make the payment; it’s generally delivered as a single lump sum.
  5. After the funds are received, they discharge the remaining balance on your account.
  6. The account is closed and the settlement gets reported to the credit bureaus.
  7. The settlement creates a negative item on your credit report that remains for seven years; the clock starts from when you missed the first payment on the original account.

How to negotiate on your own

Money PuzzleIt’s entirely possible to negotiate settlement offers on your own. You simply go to each creditor, collector or lender to make an offer. These tips can help you reach successful settlement agreements:

  • Your settlement offer must be reasonable
    • Most creditors won’t accept 5-10% of what you owe.
    • The average settlement percentage is 48%.
  • In most cases, you need a lump sum amount
    • Most creditors won’t accept a payment plan – otherwise, they’d want you to enroll in a debt management program to pay back everything you owe.
    • Things like tax refunds can be good for getting large sums.
  • Settlement typically only works once you’re in default or charge-off status
    • This is most effective for debts that are already in collections.
    • Collectors simply want to recoup at least some money; they only need to cover the cost of purchasing your defaulted debt.
    • If your account is behind but not in default, negotiate with the creditor to set up a payment plan so you can catch up.
  • You can also negotiate a settlement with the original service provider
    • If you have a bill that goes to collections, you aren’t limited to negotiating with the collector.
    • In some cases, you’ll have more success calling the original service provider to negotiate.
    • You make the settlement offer in the same way
    • This can be beneficial because they can “re-age” your account; this means they agree to remove the collection account from your credit report. This is also known as “pay for delete”

How debt settlement works if you hire an attorney

Another alternative is to work with a debt settlement attorney. This can be a good option if you’re already being sued by a collector. That way, they can handle the legal issues for you, as well as the negotiation.

  1. First, you should meet with the attorney.
    1. Make sure they are state-licensed.
    2. If a firm won’t let you meet directly with an attorney, it should be a red flag! You may be working with a scammy debt settlement company that’s impersonating a law firm.
  2. Review any problem debts and provide all correspondence that you’ve had with the creditor or collection agency.
  3. Discuss your goals, credit, and budget to make sure the attorney can negotiate a settlement that works for you.
  4. The attorney can also advise you if you have any other legal actions you can take, such as suing for collector harassment.

Responding to letters from collection agencies

Most collectors won’t wait around for you to contact them. Instead, they will send debt settlement offer letters to you. If you have a debt in collections, you may receive letters in the mail offering to settle that debt if you pay a certain amount.

If you receive a debt settlement letter in the mail, this is what you should do:

  1. First, make sure that the debt is actually yours.
    • Collectors don’t always have the right person when they send these letters.
    • Verify that the account is one of your credit cards that was charged off or a bill you didn’t pay.
  2. Next, make sure the debt isn’t past the statute of limitations. This varies from state to state.
    • Collectors can’t sue you once a debt is too old. However, there’s no law that prevents them from continuing collection attempts until you tell them to stop.
    • If the debt is past the statute of limitations, send them a cease and desist letter that says you no longer wish to be contacted.
  3. Once you confirm the debt is yours and not past its statute, review the offer to decide if it’s in your best interest.
    • Is the amount something you can afford to pay?
    • Are they offering pay for delete or re-aging?
  4. Based on what you decide, you send a debt settlement counteroffer letter OR a settlement acceptance letter.

If you receive settlement letters and you are not comfortable negotiating on your own, contact an attorney. Then, give them the letters you receive and discuss whether the offer works for you. The attorney can handle the rest.

How to negotiate with debt collectors for a lower settlement

Calculating the right amount

If you receive a debt settlement letter and don’t like the settlement percentage they offer, negotiate a counteroffer. You can do this on your own or hire a debt settlement attorney to negotiate on your behalf. In general, you want to respond by letter so there are copies of all correspondence and a record of the negotiation. Don’t just call the collector’s office. Verbal agreements may not be honored later!

In your letter, make sure to include:

  1. Your name and address.
  2. The original creditor’s name and address, if you have it.
  3. Your collection account number.
  4. The date you received their settlement offer and the amount.
  5. The amount you propose to settle the debt in full.

You can find a debt settlement counteroffer letter sample further down this page.

How to recover from debt settlement

Each debt you settle creates a negative item that appears on your credit report. Settled debt is bad for your credit history, so settlements also drop your credit score. These penalties remain for seven years from the date the account first went delinquent.

The good news is that you don’t need to wait seven years to rebuild your credit. The “weight” of negative items decreases over time. Positive credit history offsets negative credit history from the past.

These tips can help your credit recover quickly from settlement:

  • Minimize the number of debts you settle
    • Each settled debt eliminates one bill.
    • Review your budget to see if you can afford to pay off other debts in-full.
  • Start building positive credit history immediately
    • Make all payments for your other accounts on time.
    • Be careful with things like out-of-pocket medical expenses; these can easily become collections when you think a bill was covered by insurance.
    • If you don’t have many accounts to make payments on, consider a secured credit card.
  • Know how to “game the system” when it comes to credit scoring
    • Don’t open too many new accounts within a 6-month period.
    • Keep your credit utilization below 30%; this means you only use a third of the total credit limit you have available.
    • Don’t let any one card run up to its limit.
    • Don’t close old accounts that you’ve maintained in good standing; make sure to keep your accounts active.

Writing Debt Settlement Letters

Use this letter sample

This is a debt settlement letter sample can be used to propose a settlement offer to a creditor or service provider. It includes a pay-for-delete stipulation to re-age the account once the settlement is made.

Download’s settlement offer template »

Debt settlement counteroffer letter sample

This debt settlement offer letter sample is designed to make a counteroffer if you receive a settlement offer from a creditor or collector. It includes a pay-for-delete stipulation to re-age the account once the settlement is made.

Download’s counteroffer template »

Debt settlement negotiation tips

  • Always correspond by physical mail
    • Verbal agreements may not be honored later, so you want everything in writing.
    • Physical mail gives you proof of what was negotiated, in case the creditor or collector attempts to change the agreement later.
    • If you have the means, send letters by certified mail, return receipt requested; this will give you a formal notification and proof of when your letter was received.
    • If you receive calls from debt collectors, tell them you wish to be contacted by mail only.
  • Settlement negotiation can help you minimize credit damage
    • Always try to negotiate to re-age the account once the settlement is paid (also known as “pay for delete”)
  • Make sure a collector can verify that an account is yours before you acknowledge it!
    • The collector must be able to verify the account; if they can’t, you don’t have any liability to repay it
  • Don’t let collectors trick you into paying a debt that’s past the statute of limitations.
    • If you make a payment or acknowledge that you need to pay the debt, doing so can reset the clock on the statute of limitations.
    • If this happens, the collector reestablishes the ability to sue you in civil court to collect.

Types of Debt Settlement

Unsecured debt is any debt that is not secured with collateral. Almost any unsecured debt can be settled, as long as it is not court-ordered, like child support or alimony. Debt settlement doesn’t work for secured debts like your mortgage or auto loan. If you fail to pay a secured debt, the lender has the rights to repossess the collateral, so there is no reason to settle. has a complete list of debts that cannot be settled.

Collection account settlement

How many people faced final notice debt collection actions this year?This is when you have an account that goes into third-party debt collection. This can be a credit card that’s charged-off and sold to a debt buyer. It can also be an unpaid medical expense, utility bill or mobile plan that you haven’t paid. Your credit report shows collection accounts under Public Records.

For this type of settlement, you can generally follow the instructions for settling debt on your own. If you fail with the do-it-yourself option, you can always bring in the professionals.

Credit card debt

Credit card debt settlement is the most common type to go into a settlement program. If you get completely overextended with credit card debt, you can go into settlement to avoid bankruptcy. This can help you protect assets, like your car and home, from liquidation. It also lets you control the negotiation, instead of allowing the court to decide on the settlement agreement for you.

Learn more about credit card settlement »

Medical debt

Out-of-pocket medical expenses that are not covered by insurance are a leading cause of collection accounts. They’re also a leading cause of bankruptcy in the U.S. If you have medical bills that end up in collections, we recommend negotiating with the original medical service provider. Contact them directly to see if you can set up a partial payment plan with them. If they are not willing to negotiate, then you can always try collector debt negotiation.

Private student loans

It is possible to settle student loans, but it’s not common. Student loans – even private – are not easily discharged, even through bankruptcy. In fact, both federal and private student loans are protected from discharge, except in cases of extreme financial hardship.

Without the threat of bankruptcy discharge, student loan lenders have limited reason to settle. The only good reason they have is when the debt approaches the statute of limitations on collections. In some states, that can take as long as 15 years, so, lenders are often willing to wait it out and see if you will pay.

Still, you can settle if you’re close to the statute of limitations in your state. They may also accept an offer if you can prove there’s no reasonable expectation that you will pay.

See if you’re a candidate for student loan settlement »

Tax debt

IRS debt settlement is known as an Offer in Compromise (OIC). The IRS will only allow you to settle if there is no reasonable expectation you can repay the debt in-full. You must show that no amount of budgeting and no amount of time will put you in a position where you can pay the debt back.

If you apply for IRS OIC, expect a full and exhaustive review of your finances. The IRS will look at your assets and budget to find any way for you to pay the debt. They will consider settlement only after it sees there isn’t any feasible way to repay.

See if you qualify for an OIC »

How to Avoid Scams

One of the biggest drawbacks of debt settlement is the potential for getting scammed. Debt settlement negotiation is a legitimate business, and there are plenty of companies that can get you the help that you need. At the same time, there are also companies that just want to rip you off, so you need to be very careful that you don’t get scammed.

Beware of upfront fees

Consumer rights laws stipulate that debt relief providers (including settlement companies) must provide services before they can charge fees. This means that there should be no upfront fees charged to evaluate your situation or to set up your program. If the company takes fees before they settle any actual debt, the company must provide a money-back guarantee.

You should only be required to pay once a settlement company reaches at least one satisfactory settlement in your favor. Make sure to check the fee structure and guarantee policy of any company before you sign up for their service.

Licensed attorneys should be on staff

Federal laws also require debt settlement companies to employ licensed attorneys on staff. A debt settlement lawyer should be the one in charge of all correspondence and formal negotiation on your behalf. Make sure a provider works with licensed debt settlement attorneys before you sign up for their service. Otherwise, that company cannot legally represent you in settlement negotiations.

Don’t get scammed by a settlement offer

The final scam is not perpetrated by debt settlement companies. Instead, it’s one where collectors attempt to trick you into paying a debt that’s past the statute of limitations. Collectors are legally only allowed to pursue debt repayment for a certain amount of time. However, the law has a loophole: a collector can continue to contact you, even after the statute of limitations expires. They just can’t sue you in court anymore, and if you tell them to stop contacting you, there’s nothing else they can do.

However, if you don’t tell them to stop contacting you, and instead acknowledge that the debt is yours to repay, then this action can reset the clock. The statute of limitations effectively starts over from the point you acknowledge the debt. Now the collector has full license to pursue you for another 10 years!

Want to avoid getting scammed? can connect you with reputable, accredited debt settlement services.

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Pros and Cons

On the pro side, debt settlement is usually the fastest and most cost-effective way to get out of debt. Debt settlement programs can take as little as 12 months, while consolidation programs can take up to five years. Statistics show that most people who complete a settlement pay about 40% of what they owe. That’s significantly cheaper than other solutions that make you pay back everything you borrowed or charged.

On the other hand, settlement hurts your credit score. Each debt settled creates a negative item in your credit report that remains for seven years. What’s more, if you stop making payments to your creditors to generate settlement offers, you may face additional credit damage. Therefore, impact on your credit from debt settlement can be significant.

You also need to be very careful that you don’t get scammed. Only work with the best debt settlement companies that have an A rating or better with the Better Business Bureau (BBB). Otherwise, you could end up paying fees without getting the results you want. If you believe you are the victim of a debt settlement scam, contact the Federal Trade Commission!

Debt Settlement Questions

Do debt settlement programs work?



Yes! Just like any debt solution, this is not a silver bullet; it won’t fix every debt situation for every consumer. But when it’s used in the right circumstances, it can be extremely effective. Just be aware that not all debt settlement companies are good. Some of them are scams. They charge huge fees up front, take your money and disappear.

Always make sure to work with a settlement service that doesn’t charge fees up front. Companies that offer a money-back guarantee can be good, too. Then check the company’s rating with the Better Business Bureau and read third-party reviews. As long as a company is above board and they say you’re a good candidate, a settlement program can work.

How bad does debt settlement hurt your credit?



The impact on your credit depends on your existing credit profile. If you have perfect credit, then a settlement can affect you significantly; it’s likely you’ll lose your excellent credit rating. However, if you have a low score and already have lots of credit damage, then the actual point-decrease on your score may be less.

Just keep in mind two things:

1. The settlement remains on your credit report seven years from when the account first became delinquent.
2. The “weight” of negative items on your score decreases as time goes by

This means you can build credit long before the penalty for settlement expires. It also lets you know when you should review your credit. You want to make sure the negative item disappears at the designated time.

How does debt settlement affect your taxes?



This is an important question. The IRS counts forgiven debt as income. Essentially, the IRS expects you to pay taxes on the discharged balance. If you owe a creditor $20,000 and settle for $8,000, then you must pay taxes on the $12,000 you didn’t pay.

The good news is that you can request get the IRS to waive this tax liability. You basically need to show that you settled the debt during a period of financial hardship. If you can show you couldn’t afford to pay the debt, then you also effectively show you can’t afford to pay the taxes on it either.

How long does debt settlement stay on your credit report?



7 years from the date of final discharge. Once the collector accepts your settlement offer and you pay them the agreed amount, they discharge the remaining debt. The 7-year clock starts from that date.

How long does debt settlement take?



Making a single settlement offer and setting up and agreement can take as little as a month. If you enroll in a debt settlement program, then it generally takes about 24 to 48 months to complete the program. A 24-month settlement program is often a much shorter timespan to get out of debt than other solutions, such as debt management programs.

Is a debt settlement plan better than credit management?



A credit management plan (also known as a debt management plan) is a type of assisted debt consolidation. Consumer credit counseling services offer a debt management plan to consumers who do not qualify for other types of consolidation. These assisted credit management plans are basically a last resort to save your credit. When executed correctly debt management plans don’t damage your credit score. This can make them preferable to debt settlement, assuming you don’t want to damage your credit.

However, if your score has already suffered from your challenges with debt, you may not care about credit score damage. In this case, you simply want a fast, affordable exit. This is when debt settlement may be the better option. To learn more, look at the debt consolidation table at the bottom of this page.

Is debt settlement bad?



This depends on your goals. Is debt settlement bad for your credit? Yes. So, if you have an excellent credit score and don’t want to damage it, then settlement is extremely bad. However, if your score has already taken hits from late payments and collections and bad credit is not a concern, then settlement can be good. Settling your debt can give you a fast exit where you control the discharge. It helps you avoid bankruptcy, where the court controls the discharge agreement (Chapter 13) or liquidate your assets (Chapter 7) to settle your debts.

Is debt settlement better than bankruptcy?



If you’re comparing debt settlement vs bankruptcy, debt settlement is usually the better option. The main reason is that it puts you to control the debt settlement negotiation. You’re, your own attorney or the settlement company can make counter offers and ensure that the settlement offer works for your budget.

With bankruptcy, you put the control in the court’s hands. The court-appointed trustee has the final word in what settlement you reach. If you use Chapter 7 bankruptcy, your assets will be liquidated to cover the settlement. If you use Chapter 13, the court will set up a settlement payment plan. It’s basically like the set aside that a debt settlement company would arrange. But again, you don’t have any final say about what settled they reach.

Going for debt settlement first before you file for bankruptcy makes sense. You can protect your assets and control whether you accept or reject a proposed settlement offer. We recommend taking care of as many debts as you can through settlement. Then you can decide if you want to file for bankruptcy for anything that’s left. But once you settle a few debts, it may fix your budget enough that you can avoid bankruptcy entirely.

If you’re in doubt about which option is better, you may want to contact a debt settlement lawyer. They can provide legal advice on whether settlement is a viable alternative to declaring bankruptcy.

What is better debt consolidation or debt settlement?



Comparing debt consolidation vs debt settlement, depends heavily on your financial situation and goals.

When Debt Consolidation is BetterWhen Debt Settlement is Better
Most of your debts are still current with the original creditorsMost of your debts are in charge-off or default status
You want to avoid credit damageThe debts you want to settle are in collections
You have a good credit scoreYou’re not concerned about credit damage
You have the ability to make monthly paymentsYou don’t have the credit score or income to qualify for consolidation

Essentially, the main goal of debt consolidation is to reduce or eliminate the interest rate applied to your debt. You also generally want to stop late fees and other charges. But a debt that’s already in collection doesn’t have interest charges or late fees. Consumer rights protections prohibit collectors from adding charges to a debt that’s already in collection. So, if you can’t benefit from reducing your rates and eliminating fees, then settlement may be the better option

Want to know which debt solution is right for you? Talk to a certified consumer credit counselor for a free evaluation

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Article last modified on May 15, 2019. Published by, LLC .