When is Debt Settlement a Good Idea?

Last updated 03/28/2024 by

Many debt settlement companies claim to help you settle your debt for at least half of your outstanding balance. But does this offer ring true? What can debt settlement really do for you? How do you know when to settle debt, and when will it do more harm than good? Let’s explore the risks and benefits of debt settlement so that you can decide if it’s the right path for you.

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What is a debt settlement?

Debt settlement companies claim to help you settle, renegotiate, or change the terms of your debt with your creditor or debt collector. Usually, once you sign up for debt settlement, you stop making payments on your credit account(s). Instead, your money is put into an account where it can grow into a lump sum.

Once you’ve accumulated enough money in your account, the debt settlement company will contact your creditor to attempt to settle your debt for less than you owe. If they agree to settle, your debt will be closed, which will stop further collection attempts.

At this point, the debt status on your credit report is updated to “Settled” or “Paid settled.” Note that this status is better for your credit than “Unpaid,” but it’s still worse than “Paid in full.” A “Settled” status can negatively impact your credit score for seven years.

Also, according to the IRS, you must include any canceled, discharged, or forgiven debt as taxable income on your tax return (though some exceptions apply). Now that you know the basics, how do you know when to settle debt?

The average debt-settlement customer enrolls seven accounts with an average balance of $4,132 each.

When is debt settlement a good idea?

Wondering when to settle credit card debt? Here are a few situations wherein debt settlement may be a good option.

If you’re considering declaring bankruptcy

Are you considering filing for bankruptcy? If so, you’re backed into a tight enough corner that you’re willing to sacrifice your credit for a new start. In this situation, debt settlement can help you resolve your debt and move forward while doing less harm to your future credit. Bankruptcies can stay on file for up to 10 years, while debt settlement falls off after seven.

Additionally, if you file a Chapter 7 bankruptcy, you may have to liquidate some of your assets. And in a Chapter 13 bankruptcy, you’ll have to commit to a three-to-five-year payment plan. Debt settlement doesn’t necessarily require either of those (though in some cases you will initiate a payment plan).

In other words, if you are considering bankruptcy, you don’t have much to lose by attempting to settle the debt first. Plus, creditors usually get little-to-nothing if you file bankruptcy, so you can use it as leverage when negotiating your settlement.

If you owe more than you can pay

If you owe more than you can pay to your creditors, then you are likely already watching your credit score drop as you miss payments. Debt settlement will cause your score to drop further, but it also provides a light at the end of the tunnel. If you aren’t ready to file bankruptcy but need to cut your losses on a credit account or two, debt settlement may provide the relief you need.

If you’re buried in interest

Lastly, if your interest rate is so high that most of your payments go to interest rather than your principal balance, it’s time to rethink the debt. Look into refinancing to see if you can score a lower interest rate. If not, it’s time to consider debt settlement. You don’t want an expensive debt to hold you back from your future life goals, like buying a house or saving for retirement. While debt settlement may hurt your credit for seven years, it can also save you from decades of life burdened by debt.

With the understanding of when to consider debt settlement, here’s why it might not always be the best idea.

Why might debt settlement be a bad idea?

Although working with a debt settlement company offers some benefits, there are also serious risks to consider. Before you move ahead with debt settlement, consider the following disadvantages:

Expensive fees ($500 to $3,000 or more).
Increased collection efforts by creditors.
More late fees, interest, and other charges.
May lead to creditors filing lawsuits against you.
Creditors may not work with the company you choose.
The company may not be able to settle all of your debts.
Damaged credit score.
No guarantees that debts will be settled.
May owe taxes on the amount settled.
Not all debt settlement firms are reputable.

Debt settlement brings an obvious benefit: you may get away with paying far less than you owe. However, it also carries myriad risks. You will have to weigh these risks to decide if it’s the best strategy for you.

On the fence about debt settlement? You can increase your odds of success by finding a reputable debt settlement agency.

Is debt settlement right for you?

Debt settlement may be the right path if one of the above situations applies to you. The most important thing is to make an informed decision. Before you turn to settlement, be sure to consider alternatives such as:

Negotiating the debt directly with the debt collector or creditor.
Refinancing the debt.
Filing bankruptcy.
Figuring out a payment plan.
Working with a nonprofit credit counselor.

Now you know when to consider debt settlement. While these companies can potentially save you some money, there are no guarantees. To find the best debt settlement firms in the business, review and compare the firms below, complete with real-user reviews from past clients.

Jessica Walrack

Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.

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