Debt Settlement Pros and Cons: What to Know Before You Decide
Understanding the debt settlement pros and cons can help you decide whether settlement deserves consideration alongside other ways to address credit card debt. Although debt settlement may allow some consumers to resolve eligible debts for less than the full amount owed, it can also involve missed payments, additional interest and fees, credit damage, collection activity, lawsuits and possible tax consequences.
What Are the Debt Settlement Pros and Cons?
The primary potential benefit of debt settlement is that a creditor may agree to accept less than the full balance owed.
The tradeoff is risk. Debt settlement programs often involve allowing accounts to become delinquent while money is accumulated for potential settlements. During that period, interest and late fees may continue, credit can be damaged, creditors can continue collection efforts and a creditor or debt collector may file a lawsuit.
In addition, no creditor is required to accept a settlement offer, and forgiven debt can sometimes create federal income tax consequences. Looking at all of the debt settlement pros and cons before enrolling can help you compare settlement with other repayment strategies.
How Does Debt Settlement Work?
Debt settlement is different from credit counseling or a Debt Management Program. Rather than creating a structured plan to repay participating balances in full, settlement attempts to persuade a creditor or debt collector to accept less than the total amount owed.
Money Is Accumulated for Settlement Offers
Many debt settlement programs involve depositing money into a dedicated account until sufficient funds are available to make settlement offers.
Payments to Creditors May Stop
Debt settlement companies frequently encourage consumers to stop making regular payments to creditors. As a result, accounts may become delinquent while interest, late fees and collection activity continue.
Settlement Offers Are Made
Once funds are available, the consumer or settlement company may offer a creditor a reduced amount in exchange for resolving the debt.
The Creditor Decides Whether to Accept
Creditors are not required to negotiate or accept a settlement. Results can therefore vary by creditor, account status and individual circumstances.
Debt Settlement Pros: Potential Advantages
When reviewing the debt settlement pros and cons, the potential advantages generally center on reducing the amount needed to resolve certain unsecured debts.
You May Resolve a Debt for Less Than the Full Balance
If a creditor accepts a settlement, the amount required to resolve the account may be less than the total outstanding balance.
It May Be an Option During Serious Financial Hardship
Settlement may be considered by consumers who are already significantly behind and do not have the ability to repay their unsecured debt under its existing terms.
You Can Sometimes Negotiate Directly
Consumers are not always required to hire a settlement company. In some situations, a creditor or collector may be willing to discuss settlement directly with the account holder.
Debt Settlement Cons: Risks to Consider
The disadvantages of debt settlement can be significant. Before proceeding, consider what can happen while accounts remain unpaid and settlement funds are being accumulated.
Your Credit Can Be Damaged
If you stop making required payments, late payments and other negative account information may be reported to the credit bureaus. Accurate negative information can generally remain on a credit report for years.
Interest and Fees May Continue
While a settlement is being pursued, interest, late charges or other permitted fees may continue to increase the outstanding balance.
Creditors Do Not Have to Settle
A creditor is not obligated to accept a settlement offer. Therefore, there is no guarantee that every account — or even any particular account — will be settled.
Collection Activity Can Continue
Stopping payments does not automatically stop collection calls, collection letters or other efforts to collect the debt.
You Could Be Sued
A creditor or debt collector may decide to pursue legal action while you are saving money for a possible settlement. Enrollment in a settlement program does not prevent a lawsuit.
Fees and Taxes Can Reduce the Savings
A settlement company may charge fees for successful settlements. In addition, canceled debt may sometimes be treated as taxable income unless an exception or exclusion applies.
Be Careful With Guaranteed Settlement Claims
The Consumer Financial Protection Bureau warns consumers to be cautious of companies that guarantee they can eliminate debt, promise a specific percentage reduction or charge prohibited upfront fees. Before signing an agreement, understand exactly what the company charges, which debts it will attempt to settle and what happens if a creditor refuses.
Can Settled Debt Be Taxable?
Possibly. The IRS generally treats canceled debt as income unless an exception or exclusion applies.
For example, some canceled debt may be excluded when a taxpayer is insolvent immediately before the cancellation or when qualifying debt is discharged through bankruptcy. Tax treatment depends on individual circumstances, so consumers who receive a Form 1099-C or have debt forgiven may want to consult a qualified tax professional.
How Debt Settlement Pros and Cons Compare With a Debt Management Plan
Understanding the debt settlement pros and cons becomes especially important when comparing settlement with a Debt Management Program. The two approaches may both address unsecured debt, but they work very differently.
| Feature | Debt Settlement | Debt Management Program |
|---|---|---|
| Primary goal | Attempt to settle debt for less than the balance owed | Repay participating balances through a structured plan |
| Usually provided by | For-profit settlement companies or direct negotiation | Credit counseling organizations |
| Stop paying creditors? | Often encouraged during settlement accumulation | Generally no; payments continue through the program |
| Potential creditor concessions | Reduced settlement amount if creditor agrees | May include lower interest rates or other creditor concessions |
| Full principal repaid? | Not necessarily | Generally yes |
| Potential tax issue from forgiven debt? | Possible | Generally not based on debt forgiveness because principal is typically repaid |
| Collection or lawsuit risk while waiting? | Possible | Different structure; creditor participation and account status vary |
Alternatives to Debt Settlement
Settlement is only one approach to resolving debt. Depending on your financial situation, other options may deserve consideration first.
Paying the Debt Yourself
If your payments are still manageable, you may be able to accelerate repayment using a structured payoff strategy.
Try the Credit Card Payoff Calculator →Creditor Hardship Programs
Some creditors offer temporary hardship assistance directly to qualifying customers. Available terms vary by creditor and individual circumstances.
Nonprofit Credit Counseling
A credit counselor can review your debts, income, expenses and financial goals and help you understand which repayment strategies may be available.
Learn About Credit Counseling →Bankruptcy Consultation
Consumers facing debts they cannot realistically repay may also want to speak with a qualified bankruptcy attorney about the protections and consequences available under bankruptcy law.
Learn More About Debt Settlement Risks
Before enrolling with a debt settlement company, consider reviewing guidance directly from federal consumer-protection agencies.
Debt Settlement Pros and Cons: Frequently Asked Questions
Does debt settlement hurt your credit?
Do you have to stop paying your credit cards to settle debt?
Can a creditor refuse a debt settlement offer?
Can I negotiate debt settlement myself?
Is forgiven debt taxable?
Is debt settlement the same as a Debt Management Program?
Not Sure Which Debt Strategy Makes Sense?
You do not have to decide between debt settlement, consolidation or a Debt Management Program before asking for help. A DebtWave credit counselor can review your credit card balances, payments, interest rates, income and expenses and help you better understand your available options.
Free initial consultation. No new loan. No obligation to enroll.