How Debt Settlement Works and Debt Settlement Company Fees

Debt Settlement

Debt settlement is an agreement made between a creditor and a consumer in which the total debt balance owed is reduced and/or fees are waived, and the reduced debt amount is paid in a lump sum instead of revolving monthly.

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Why Work With A Debt Settlement Company?

If you’re in so much credit card debt that the best option seems to be jumping out the nearest window, please read this.

There is a better way out known as debt settlement. You should consider it, however, only if you’re currently desperate enough to be standing on the ledge of a tall building. Here’s a typical scenario:

Suppose you have $30,000 in credit card debt or other debt. Maybe you have a sob story, like you got laid off or you bet a fortune that Jeb Bush would be elected president. Whatever, you simply cannot get out of debt.

So you hire a debt settlement company to call the creditors and offer a smaller amount – say $16,000. You tell creditors if they don’t’ take it, you’ll probably have to file for bankruptcy and they’ll never see a dime.

So they bite! They accept your offer, you get out of debt for $14,000 less than you owed and get on with your life. It all sounds great, but there are plenty of reasons not to order champagne for a big “I’m-Free-Of-Debt” party.

How Debt Settlement Works

To understand why, you need to know how Debt settlement actually works. Debt settlement companies often don’t want you to know the devilish details, but there are some so here’s the skinny:

Debt settlement companies instruct you to stop making payments on your bills. Instead, you make one monthly payments to the debt settlement company. That sounds like a debt consolidation loan, but there’s a big difference.

In debt consolidation, you combine all your bills, get a loan and pay off all your debt. You are left with one payment, likely with a lower interest rate than you were paying before and the debt has been wiped out to the creditors’ satisfaction.

But the important thing is: You are paying on the bills every month.

In debt settlement, the company will instruct you to stop making payments to the creditors. Your accounts become delinquent, and the debt settlement company tries to negotiate a settlement on your behalf.

In the meantime, you give your money to the debt settlement company, who also is not paying the creditor with it. The settlement company is stockpiling the money (and taking a fee for doing so) so it has something to eventually offer the creditors.

Credit card companies aggressively try to collect overdue bills for 180 days, meaning you’ll be getting a lot of irritating calls from debt collectors while you’re debt settlement company is counting your money. After 180 days, the credit card companies usually write off the debt and it is sold to collection agencies at a fraction of its face value.

That’s when the debt settlement company comes back into play. Their goal is that at some point the creditor, usually a collection agency at this point, will agree to a settlement with you. The debt settlement company handles that from the money you have been depositing. If there is not enough money in escrow, you continue paying the debt settlement company until the debt is paid off.

The downside is there is no guarantee the creditor will eventually agree to a discounted payoff. And the late fees and really bad damage to your credit-score keep piling up until a settlement is reached.

Debt Settlement Risks

1. Fees

Many debt settlement providers charge high fees, sometimes $500-$3,000, or more. But these fees are not applied to your debt – they go straight into the agencies’ pockets. By the time these fees and future interest is added onto your total payment, any savings from the agreed settlement could be wiped out.

2. Credit score reduction

While not as devastating as a bankruptcy, a debt settlement will have a negative impact on your credit score, even if you work directly with your creditors, as the settlement may be reported by the creditor to each of the three leading credit bureaus. This will affect your future loan terms, credit availability, employment opportunities, and more.

3. Tax implications

If a creditor agrees to settle your debt in exchange for a reduced lump sum payment, you may still be responsible for paying taxes on the reduced debt. If the settlement results in a debt reduction of $600 or more, the creditor is required to notify the IRS. For example, if you owe a creditor $10,000 and they agree to settle with you for a one-time payment of $7,500, the reduced amount, $2,500 is considered taxable income.

The bottom line: If it sounds too good to be true, it probably is. Be smart: Don’t fall victim to misleading claims or pay money for something you may be able do yourself. And never sign anything you don’t fully understand. It’s your money – and your responsibility!

Average Debt Settled by Debt Settlement Companies

A study by the Center for Responsible Lending showed that on average debts are settled at 48% of the outstanding balance. But that balance increases 20 percent due to late fees and other charges the creditor might impose during negotiation.

Then there are the fees to the debt settlement company, which are typically 15%. Sometimes that is 15% of the amount you originally owed. Sometimes that is 15% of the amount you paid.

The problem is debt settlement companies often don’t make that clear to consumers. Either way, it amounts to big chunk of change. The average debt settlement customer has six debts totaling $30,000.

If you settled that at 48 percent, you’d pay $14,400. But the fee on the balance would still be $2,340, bringing your total payment to $16,740.

Debt Settlement Companies: Not Transparent About Fees And Tax Liability

There are reputable debt settlement companies out there. But the industry’s chicanery and obfuscation prompted the Federal Trade Commission to crack down in 2010 when it issued the Final Rule for debt relief companies.

It ruled that debt settlement companies that sell their services over the phone can’t charge a fee before they settle or reduce a customer’s unsecured debt. Within weeks, customers complained that debt settlement companies had switched to texting them in attempts to skirt the phone-call restrictions.

Another thing debt settlement companies don’t advertise is the IRS factor. The forgiven debt is considered income. So if you’re in the 30% tax bracket, the tax bill on a $15,600 reduction would be $4,680.

Add that to the late fees and debt settlement fees, and your total savings on a $30,000 case dwindles substantially. Then there is the effect debt settlement has on your credit score.

Lenders are still reporting late payments or missed payments to the three credit bureaus, while the debt settlement company is trying to argue your case for a lower settlement. Those are monthly body blows to your credit score.

Debt settlement typically ends up taking 60 to 100 points off your score. That means you’ll be subjected to higher interest rates on loans, assuming lenders will give you a loan at all.

DIY Debt Settlement

If you weigh all that and conclude debt settlement is still your best move, there’s one thing that might make the process a bit more attractive. You don’t have to deal with a debt settlement company.

You can negotiate directly with credit card companies and other lenders, or you can hire a lawyer to do the talking for you.

If bargaining over the phone doesn’t sound appealing, you can always send creditors a letter explaining your situation and offer partial payment. Be sure to ask that they remove delinquent payments from your credit report.

Doing it yourself could save you thousands of dollars, though when it comes to debt settlement it pays to remember there are no guarantees.

You might consider DIY debt settlement if you are being sued over credit card debt. In this case, there may not be time to work with a debt settlement company. Your creditors may prefer to work out a settlement with you than pay the legal expenses associated with going to court. However, you must be prepared, with a good chunk of change, to pay a lump sizable lump sum to achieve the settlement.

Debt Settlement Compared To Other Debt Relief Options

Debt settlement can take a few years to achieve, and that’s if your creditors agree to settle. You may find yourself making payments to the debt settlement company, just as you would to for a debt consolidation loan or to a debt management program. As long as you make on-time payments on your debts, debt consolidation and debt management won’t harm your credit the way debt consolidation will. Additionally, you may not save any more with these options, after you factor in debt settlement fees and tax liability.

Read more about debt settlement versus debt management.

If you compare debt settlement with bankruptcy, you’ll see that with Chapter 7 bankruptcy you can eliminate all of your debt, whereas debt settlement only settles a portion.

Credit Counseling As An Alternative to Debt Settlement

A reputable credit counseling provider can help you find a debt solution that fits your personal financial situation. These non-profit consumer agencies offer free counseling sessions, which include a budget evaluation, online, via phone or face-to-face. They assess your total financial picture to make recommendations accordingly, and guide you towards a customized solution. Depending on your situation, they may be able to enroll you in a debt management program with lower interest rates and fees, to help you pay off your debt faster than you may be able to on your own.

InCharge Debt Solution’s debt management program is a good alternative to debt settlement. With a debt management program, the credit counseling agency consolidates your payments, so you still make one easy monthly payment without borrowing more money. Additionally, you may qualify for waived fees and lower interest rates.

How Does a Credit Card Settlement Affect Your Credit Score?

Credit card settlement (agreeing with a card company to pay less than what is owed) reduces your credit score, with the greatest damage done to consumers with high scores.

FICO scores range from 300 to 850 depending on how well you handle credit. If you can’t pay your credit card and the company agrees to take a lesser amount, it is reported as “partial payment accepted” or “debt settled” and stays on your credit report for seven years.

According to 2017 FICO statistics, a consumer with a 780 score will lose 105 to 125 points if he or she settles a credit card bill instead of fully paying it off. A consumer with a 680 score will see their FICO score lowered 45 to 65 points.

What Is the Difference between Debt Consolidation and Debt Settlement?

Debt consolidation combines two or more debt accounts into a single debt with one interest rate and one monthly payment. Instead of paying bills separately, you make a single payment to a financial institution or debt management company. The payment should lower than the combined individual payments you were paying previously.

Debt settlement is when your creditor agrees to let you pay a sum that is less than what is owed. Unlike debt consolidation, the principal of the loan is reduced. Unlike debt consolidation, this strategy adversely affects your credit score for seven years.

Debt Settlement Pros & Cons

Commercials for debt settlement make a lot of bold claims, but from a trampled credit score to tax implications, find out the real price of debt settlement.

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Debt Management vs. Debt Settlement

Debt settlement and debt management are two approaches to reducing your debt. Both take years to achieve and both involve fees.

Learn More

Debt Consolidation

There are several types of debt consolidation, but in general, it combines your monthly bills into one consolidated payment – ideally at a lower interest rate.

Learn More


(NA) (2010, Oct. 27). Debt Relief Companies Prohibited from Collecting Advance Fees Under FTC Rule That Take Effect October 27, 2010. Retrieved from

(Harnick, E. and Parrish, L.)(2013, Nov.) A Roll of the Dice: Debt Settlement Still a Risky Strategy for Debt-Burdened Households. Retrieved from
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(Carrns, A.)(2014, July 8) Report Says Debt Settlement Companies May Leave Clients Worse Off. Retrieved from

(Niesen, J.)(ND). Debt Settlement – What Percentage of Debt is Typically Accepted in a Settlement? Retrieved from