Is Debt Settlement a Good Idea?

Debt settlement can offer a lifeline for consumers who are struggling with overwhelming debt.

When you pursue debt settlement — also called debt relief, debt negotiation or debt resolution — you attempt to get creditors to agree to accept a payment that’s less than what you actually owe. One industry study found that consumers who successfully settled accounts reduced their debt load by about half.

That may sound like a no-brainer. But debt settlement isn’t the best solution for everyone. And even if it seems like a good option for your situation, it’s crucial that you understand the potential risks as well as the possible rewards.

Can debt settlement help with your situation?

The basic concept behind debt settlement is that your creditors may be willing to negotiate and ultimately accept a smaller amount in exchange for closing the account. Typically, the process requires that you’ve fallen behind on your unsecured debt — think: credit cards and personal loans — and that you have some explanation as to why you can’t pay. (You can’t settle certain types of debts, including secured loans, federal student loans or tax debt.)

“Everybody’s financial situation is different. In general, though, debt resolution tends to be the right solution for somebody who is in the midst of an acute financial crisis,” says Steve Boms, president of Allon Advocacy and the legislative director for the American Association for Debt Resolution. People who are a good fit for debt settlement are usually juggling multiple unsecured debts and have experienced some hardship, such as a job loss, medical issue or divorce.

You can attempt to negotiate a debt yourself (see a step-by-step guide). But this can be a lengthy, stressful experience, so some consumers turn to for-profit debt relief companies.

When you start working with a debt relief company, you’ll go through a thorough consultation — some companies report this call lasts two hours — during which you’ll cover your debts and finances. If you haven’t already, the company may recommend that you stop paying your bills to your creditors.

Stopping payments is optional, although it is an important component of the process, as it helps you get leverage so creditors will negotiate. But delinquencies can (and likely will) damage your credit score, possibly dropping it by 100 points or more. That’s why this solution is best for people who have already fallen behind on their payments or are on the verge of doing so.

In the meantime, you’ll also need to make deposits in a dedicated savings account. After you build up enough money, the company will reach out to a creditor, and if they reach a deal, they’ll send the terms for you to review. Once you approve it, the company will pay the creditor, collect its fee and then move on to the next account.

Is debt settlement good for consumers? The bottom line: It depends on whom you ask. When successful, debt settlement can help consumers to finally get a handle on their debts — and the debt relief industry will highlight the stories and stats that demonstrate that.

But for those who aren’t able to reach agreements with creditors, the extended delinquency that comes with settlement can leave them worse off than they were when they first enrolled, consumer groups warn.

Should you work with a debt settlement company?

Although you can talk with creditors on your own, debt relief industry representatives often stress that they’re able to bring more expertise to the negotiating table at a time when borrowers are overwhelmed.

There are plenty of services consumers outsource for a fee, Boms says, noting that, as an example, you don’t have to work with a realtor to buy a house. When you negotiate on your own, the creditor’s only incentive is to extract as much money from you as they can regardless of what you owe others. But debt relief companies earn a fee for every debt they successfully settle.

Plus, the companies have knowledge from working with tens of thousands of different consumers who’ve settled with your same creditors, he says. That helps them determine the best time to settle and what is or isn’t a good settlement amount.

“They’ve got the relationships with those creditors to get better outcomes for you, and they’re looking at your entire portfolio of unsecured debts, not just one,” he says.

Boms thinks much of the stigma against debt relief companies stems from how the industry operated before federal rules came into play in 2010. Now, thanks to rules from the Federal Trade Commission, or FTC, these companies cannot charge upfront fees and consumers have the power to approve settlements before they’re charged a fee. Consumers have to receive clear program disclosures and they retain control of their savings account throughout the program, per the FTC guidelines.

Those rules helped align incentives — “the companies only have a revenue event when they’re successful on your behalf,” Boms says.

Still, consumer advocate groups like the National Consumer Law Center and government agencies like the Consumer Financial Protection Bureau stress that debt relief can be risky.

When you stop making payments to your creditors, that will trigger late fees and interest charges, meaning your debt will continue to grow while you wait to see if creditors will negotiate. On average, account balances grow by $494, or 12% of the original amount, according to industry statistics.

That isn’t necessarily a problem if you can reach settlements on enough of your accounts that you walk away with some net savings. And many clients of debt settlement companies do: About 6 in 10 clients between 2011 and 2020 were able to settle more than half of their enrolled debt, and 23% reached settlements on all their debt, according to a report commissioned by the American Association of Debt Resolution (AADR), the industry’s trade group.

But the same report shows that a quarter of clients weren’t able to reach a settlement on any of the accounts they enrolled, and it’s not clear how much those particular balances may have grown during the negotiation attempts.

What are your other options to get rid of debt?

If you can afford to make the payments on your debt, you’re likely better off pursuing another strategy to get a handle on your bills. If you need some help budgeting, for example, you can talk with a credit counseling organization that offers debt management plans. These come with a small monthly fee. In exchange, you’ll typically get a reduced interest rate and a single monthly payment. Or if your credit is relatively strong, you may want to consider debt consolidation as a way to simplify your bills and save on interest.

If, on the other hand, you don’t have enough income coming in to build up money for negotiations, then debt settlement also may not be a fit. Instead, you may want to consider filing for bankruptcy.

Finally, if you do decide to work with a debt relief company, remember that although you’re likely stressed about your finances, you shouldn’t make any knee-jerk decisions. Be sure the company you’re thinking about enrolling with is accredited by the AADR and check online review sites.

You should be presented with a thorough disclosure and overview of the process that explains what to expect. Then you can (and should) continue asking questions until you have a clear picture of how much of your debt could be settled, what you’ll owe the company, how long the process will take and what resources, if any, are available should you be sued by creditors. Some companies offer legal support and include that in their fee, while others may charge for it.

More from Money:

Here’s Exactly What Happens When You Work With a Debt Relief Company

Will Debt Relief Really Tank Your Credit Score?

5 Must-Ask Questions Before You Sign Up With a Debt Relief Company