Debt Settlement: Cheapest Way to Get Out of Debt? (2024)

If you are in debt and can't pay your bills, is a debt settlement program the cheapest way out of debt? It can be—particularly if you have a lot of high-interest debt—but it will depend on the specifics of your situation.

Debt settlement companies work with your creditors to bargain your current debt down to a level that you can afford, but they charge fees to handle the negotiations on your behalf. While you may end up owing less to your creditors, those fees can eat into your relief.

What Is Debt Settlement?

Debt settlement, also called debt relief or debt adjustment,is the process of resolving outstanding debt for far less than the amount you owe by promising the lender a substantial lump-sum payment.In some cases, this is known as a discounted payoff (DPO). Depending on the situation, debt settlement offers might range from 10% to 80% of what you owe. The creditor then has to decide whether to accept.

“Debt settlement can save consumers money by allowing them to resolve their debts for less than the full balance,” said Gerri Detweiler, co-author of the e-book Debt Collection Answers: How to Use Debt Collection Laws to Protect Your Rights. “It can be a way out of debt for some individuals who can’t afford to pay back the full amount they owe,” she added.

Consumers can try to settle their debts on their own or hire a debt settlement company to do it for them. In the latter case, you’ll pay the firm a fee that’s calculated as a percentage of your enrolled debt. Enrolled debt is the amount of debt you have when you enter the program. By law, the company can’t charge this fee until it has settled your debt. Fees average 15% to 25%.

Debt settlement may also entail tax costs. The Internal Revenue Service (IRS) generally considers forgiven debt to be taxable income. If, however, you can demonstrate to the IRS that you are insolvent, you won't have to pay tax on your discharged debt.The IRS will consider you to be insolvent if your total liabilities exceed your total assets.

Debt Settlement Strategies and Risks

Ironically, consumers who enroll in a debt settlement program because they can’t manage their debt burdens—but who have still been making payments, even sporadic ones—have less negotiating power than those who have made no payments. The first step that debt settlement companies recommend is often to stop making payments altogether.

Becoming delinquent on debt and settling the debt for less than you owe can have a severe impact on your credit score—likely sending it into the mid-500s, which is considered poor.The higher your score before you fall behind, the larger the drop.Late payments may remain on your credit report for up to seven years.

Making no payments also means accumulating late fees and interest, which add to your balance and will make it harder to pay off your debt if you can’t settle. Consumers can expect harassing debt collection phone calls once they become delinquent. Creditors also might decide to sue consumers for debts above $5,000—debts that are worth their trouble, in other words—which can result in wage garnishment.

“The more money you have available to settle, the sooner you can resolve the debt. The longer your debt goes unpaid, the greater the risk of being sued,” Detweiler said.

There are no guarantees that after you’ve incurred this damage the lender will agree to a settlement or settle the debt for as little as you had hoped.For example, Chase won't work with debt settlement firms.It will only work directly with consumers or nonprofit, licensed credit counseling agencies that help consumers.The Consumer Financial Protection Bureau (CFPB) cautions that the accumulated penalties and fees on unsettled debts could cancel out any savings that the debt settlement company achieves for you, especially if it doesn’t settle all or most of your debts.

Debt Settlement vs. Bankruptcy

Debt settlement isn't the only option for those who find themselves overwhelmed with debt. Chapter 7 bankruptcy involves liquidating the debtor’s nonexempt assets and using the proceeds to repay creditors. Exempt assets vary by state but often include household and personal possessions, a certain amount of home equity, retirement accounts, and a vehicle.

Compared with debt settlement, Detweiler said, “If a consumer is eligible for Chapter 7 bankruptcy, it may be a faster option. It is a legal process that can stop collection calls and lawsuits. Debt settlement doesn’t offer those guarantees.”

Still, she adds, “There may be a variety of reasons why Chapter 7 may not be a good option. A consumer may have to surrender property they may feel they need to keep. Or they may not want their financial troubles to be a matter of public record.”

Individuals could also find their job options limited if they declare bankruptcy, as some employers check on applicants’ credit histories as part of the hiring process.

Another problem that many indebted consumers face is not being able to afford a bankruptcy attorney. And in some cases, the court may reject their filing.

Chapter 7 bankruptcy can be over and done with after three to six months, compared with what could be years for debt settlement.It can be less stressful and may allow your credit score to recover faster,though bankruptcy will remain on your credit reports for up to 10 years from the filing date.

Debt Settlement vs. Minimum Monthly Payments

Making minimum monthly payments on high-interest debt isn't a good option for consumers who want to save money. It can take years—even decades—depending on how much debt you have and what the interest rate is. Interest typically compounds every day on your entire balance, and with minimum payments, you make little progress in paying your balance down each month.

Consistently making minimum monthly payments and forking over tons of interest might make you highly profitable to your creditors. A solid payment history is good for your credit score, but spending more than you have to on interest is a very expensive way to boost your credit score. A good credit score won’t pay for your retirement; money in the bank will.

Furthermore, if the amount of available credit you’ve used is high relative to your credit line, that will hurt your credit score and potentially negate the effect of your consistent, timely payments.

Debt Settlement vs. Credit Counseling

Credit counseling is a free or inexpensive service provided by some nonprofits and government agencies. Interestingly, these services are often partly funded by credit card companies.By enrolling in a debt management plan with a credit counseling agency, you may receive an interest rate reduction on your balances and a waiver of penalty fees.

Those concessions may or may not be sufficient to help you pay down your debt considerably faster, and you may or may not be able to afford the new required monthly payments.In addition, you might not qualify for an interest rate reduction, even if you have a significant financial hardship.

However, because you won’t have to default on your debt, your credit score may suffer less. Also, credit counseling may offer additional financial assistance that can help you avoid similar problems in the future, such as budgeting advice and financial counseling, as well as referrals to other low-cost services and assistance programs.

So, how do you know which option to choose if you don’t want to file for bankruptcy? It’s usually better to pursue credit counseling before you consider contracting a debt settlement company. Credit counselors can help you determine the best course of action. That may include debt settlement, but in a way that benefits you the most. On the other hand, a debt settlement company may be more interested in your fees than the health of your credit.

Credit counseling and debt consolidation loans are appropriate for consumers with more modest financial stress on the spectrum of financial hardship. At the same time, debt settlement and bankruptcy can help those who have more significant financial stress. It is very dependent on the individual situation. Debt consolidation offers the benefit of lower debt repayment costs without hurting one's credit. Debt settlement, however, significantly impairs credit because it involves cessation of payments to creditors while the debt settlement company begins to negotiate to reduce the customer's debt with their creditors to some level below what is owed.

The Federal Trade Commission website has helpful information about how to choose a credit counselor. The National Foundation for Credit Counseling is another good resource.

The Bottom Line

Debt settlement can sometimes be the least expensive way to get out of debt. It depends in part on how much you owe, and there are other factors to consider, such as how much time it takes and how stressful you might find it compared with the alternatives. It’s important to think through the pros and cons of debt settlement before you choose it—and to make sure that you’re dealing with a reputable company if you do.

The best approach is to research all options. “If you are struggling with debt, talk with a credit counseling agency, a debt settlement expert, and a bankruptcy attorney, so you understand your various options and make an informed decision,” Detweiler said.