Debt settlement is one of those concepts that works better in theory then it does in reality. So don't get stuck with a bigger problem than you already have.

Millions of Americans are struggling under the weight of debt they can barely afford the pay. Sooner or later, it reaches a point where you’re facing a full-on financial crisis. That’s when it’s time to consider options for dealing with your debt. Options like debt settlement.

But does debt settlement work?

It’s actually a complicated process, and there are so many different debt settlement practitioners that the methodology is hardly standard. In fact, there are a lot of shady operators, taking advantage of people in debt. They charge high fees, and don’t necessarily end up settling the problem with the creditors.

Let’s do a deep dive into debt settlement, including what it is, how it works, whether you should try it, and any alternatives you might consider.

How does debt settlement work?

Debt settlement is a basic process of attempting to make a debt situation more manageable. Either you, or a credit professional, works with your individual creditors to produce a payment plan that will be both more workable within your budget, while eventually paying off your debts.

There are several methods that are common in debt settlement arrangements:

  • Settling a debt for less than the full amount owed.
  • Getting the monthly payments reduced.
  • Having the interest waived.
  • A reduction in the principal balanced owed.

Some people attempt to work out a debt settlement on their own. This can work if you’re a strong negotiator, and you have a solid understanding of the credit process. But most people are completely unqualified for this task.

In those situations, it’s best to be represented by a debt settlement agency.

There are all kinds of debt settlement firms, which is actually part of the problem. Some are just groups with very limited experience, who are looking to take advantage of people in desperate circumstances. They’ll charge high fees—usually collected up front—without any guarantee of cooperation from the creditors.

The best debt settlement option

If you’re going to get representation for debt settlement, the best option is always to go with a law firm that specializes in credit. There are several reasons why this is true:

  • Attorneys know the credit laws in your state.
  • Creditors are more likely to cooperate with an attorney than with a debt settlement company or an individual.
  • Attorneys can apply appropriate legal threats and remedies when necessary.
  • Credit law firms often have experience dealing with certain creditors, and usually know exactly who to contact.
  • They know how to set up a payment agreement, or to re-negotiate a debt, and to do it in a legally binding way.

Not everyone chooses to use an attorney to represent them in a debt settlement situation. This is likely because a law firm will charge a higher fee than a non-attorney firm.

Why would a creditor agree to a debt settlement plan?

Loan default is an occupational hazard in the lending field. Lenders know a certain number of loans will go sour. Their mission, when default looms, is either to avoid the default in the first place, or make every attempt to collect at least some of the amount owed.

Lenders are keenly aware a borrower who’s too deep in debt could file for bankruptcy. And if that’s the case, the lender could end up with nothing. That’s why many will work within a debt settlement plan. However, they’re more likely to work with a well-structured plan prepared by an attorney, than one by a non-attorney firm of questionable reputation.

Does debt settlement work?

Debt settlement can work, but the outcome is not universal. As we’ve already discussed, working with the wrong debt settlement company could leave you in an even worse position than when you started.

Debt settlement can often work under the following circumstances:

  • You’re working with a reputable debt settlement company.
  • You have sufficient income to pay at least a reduced monthly payment.
  • You have some liquid cash that will enable you to settle some debts for less than the full amount owed.
  • You’re committed to making monthly payments regularly and on-time.
  • All your creditors agree to participate in the plan.
  • The plan succeeds in lowering your monthly payment, either through reduction of the principal amount owed, or reduction or elimination of the interest on the debt.

If even one of these factors is out of line, the debt settlement can fail.

For example, if you don’t have sufficient income to make an acceptable monthly payment, or you’re unemployed, the plan isn’t going to work. And if you don’t have at least some ready cash to settle some debts, you may not be successful in lowering the total amount owed.

There’s also the possibility that one or more creditors may choose not to cooperate.

Why you should (or shouldn’t) try debt settlement?

There are at least three factors that will determine if you should try debt settlement—or not.

Your willingness to make the program work

A debt settlement plan won’t work without your cooperation. Unfortunately, many debtors use debt settlement as a stall tactic.

Some figure it will hold off the creditors long enough for them to arrange some sort of bail out. This is a dangerous practice, because most bailouts don’t happen. And if they don’t, your creditors may fail to cooperate with you going forward.

The amount of your debt compared to your financial resources

If you lack sufficient income and assets, there’s no point even entering into debt settlement. Bankruptcy will be a better option, which we’ll discuss in a little bit.

Some or all of your debts were obtained fraudulently

Unfortunately, it’s not unusual for people to stretch the truth when applying for credit.

Credit agreements have a more than generous amount of fine print. At least some of it warns you against providing less than truthful information about your employment and income.

If the creditor is aware that you overstated your income, they can assert a legal claim against you for the full amount owed. This won’t necessarily eliminate the possibility of a debt settlement agreement. But it can seriously restrict your options, and that of an agent who is negotiating for you.

The effect of debt settlement on your credit

No discussion of debt settlement would be complete without considering the implications it will have for your credit and your credit score. Even if your debt settlement is successful, meaning your debts are completely paid upon completion of the plan, your credit is likely to be destroyed.

When you enter into a debt settlement plan, it’s important to realize that you are defaulting on your original loan agreements. Sure, the creditor may agree to accept a reduction in interest, and even the elimination of interest. And in the end, your obligations may be fully met according to those agreements.

But when it comes to your credit profile and your credit score, the only thing that matters is how well you performed on your loans based on the original agreements.

If you have a 60-month loan, at 10 percent interest, with a monthly payment of $300, and in month 22, the interest on the loan is waived, and the monthly payment drops to $180, you will have defaulted on the loan, based on the original terms.

That’s how the lender will see it, and how they’ll report it to the credit reporting agencies.

What your credit report will look like during and after the debt settlement

Your credit report will show a laundry list of the following entries:

  • A series of 30-, 60-, 90- and 120-day late payments with each creditor.
  • Charge-offs and collections.
  • A series of loans and credit lines showing “Account settled for less than the full amount owed”.

One or more of these notations will appear on every one of the loans and credit lines included in your debt settlement. They will appear even after the debt settlement, when each of the loans has been satisfied. The derogatory information will remain on your credit report for up to seven years from the time each loan went into default under the plan.

Ironically, the fact that the creditors agreed to your debt settlement plan may not even appear on your credit report. That’s because a debt settlement plan is more of a “gentleman’s agreement” than a legally binding arrangement.

Alternatives to debt settlement

Hopefully, in considering all of the above, you’ll recognize the reality that no matter how positively it’s presented, debt settlement is far less than a perfect option. There are other alternatives, and you should consider them carefully before entering into a debt settlement agreement.

The three primary alternatives are bankruptcydebt consolidation, and balance transfer credit cards. Which you choose will depend upon your financial circumstances.


If you lack the financial resources to make a debt settlement plan work, you’ll need to consider filing for bankruptcy. The advantage of bankruptcy is that it’s a legal discharge of your debts.

As soon as you file, all collection efforts by your creditors must stop, interest charges halt, and creditors must recognize and accept the terms of the bankruptcy as final.

Chapter 13 bankruptcy

Chapter 13 bankruptcy is the form in which you agree or are required by the court to make monthly payments toward your debts. Those payments may not be sufficient to completely satisfy all your debts, but the entire payment structure will be based on your income.

The bankruptcy trustee will determine the setup of the plan based on the amount of your debts, income, living expenses, and any assets you have.

A chapter 13 bankruptcy will generally enable you to save certain assets, such as protecting your house from foreclosure. It may also enable you to keep your automobile and certain other assets. However, any financial assets may be taken by the court and distributed to your creditors. Employer sponsored retirement plans, and IRA’s in most states, are usually protected from seizure.

Chapter 13 bankruptcy payments are normally based on how much you can pay each month, based on a 60-month payout. Any debts that cannot be satisfied under those terms will be discharged with the bankruptcy. The bankruptcy will be officially and legally discharged at the end of the five-year payment plan.

Chapter 7 bankruptcy

Chapter 7 bankruptcy is total and immediate discharge of your debts. It’s designed for debtors who lack the financial capability to enter into a debt payment arrangement. This is normally the case with someone who is unemployed, lost a business, or is dealing with a major life event.

The advantage to a chapter 7 bankruptcy is that you don’t have to make monthly payments, and the discharge is immediate. However, the downside is that you can lose major assets.

Your financial assets will be taken by the court to pay your obligations. You may lose your home or your car. Each state has guidelines as to how much equity in either is considered to be exempt in a bankruptcy proceeding. If your equity exceeds those limits, the asset can be sold and the proceeds used to pay your creditors.

Whether you file for chapter 7 or 13, your credit will be impaired for a long time. A chapter 13 bankruptcy will stay on your credit report for seven years from the date of filing. A chapter 7 will stay on your credit report for 10 years after discharge.

Debt consolidation

If you have the financial means, debt consolidation is usually the better route for dealing with excess debt. You can often get out of debt in less time than a Chapter 13 bankruptcy, and with none of the credit damage that’s done by either bankruptcy or debt settlement.

Typically, that consolidation involves putting all of your various loans into a single loan, with one monthly payment. The interest rate is frequently lower than the average interest rate of all the debts you’re paying now, which can result in a lower payment.

But just as important, debt consolidation loans have a fixed interest rate, as well as a set term. That means your payment remains the same for the life of the loan. Best of all, at the end of the term—which is generally between three and five years—you’re completely debt free.

Four services that specialize in debt consolidation loans are:

Lending Club

lendingclub_210Lending Club is a peer-to-peer (P2P) lender, where you can obtain a personal loan that’s funded by investors on the platform. (Translation: there’s no bank process to go through).

You can get a personal loan for up to $40,000, for any purpose, including debt consolidation. Loan terms are either three years or five years, with interest rates between 6.95 percent and 35.89 percent APR, depending on your credit profile.

They also charge a one-time loan origination fee that’s between one and six percent of your loan amount.

The minimum credit score requirement is 640.


Upstart 210Upstart works similar to Lending Club, except Upstart partners with participating banks.

You can get a personal loan for up to $50,000, for debt consolidation, or any other purpose. Loan terms are three or five years, and interest rates range between 7.69 percent and 35.99 percent APR, based on your credit profile.

Upstart requires a minimum credit score of 620.


Payoff 210With Payoff you can borrow up to $35,000 to pay off your debt.

Interest rates range between 5.99 percent and 24.99 percent APR. Loan terms are between two years and five years, and they charge an origination fee of between zero and five percent of the loan amount.

The minimum credit score requirement is 640.


Prosper 210Prosper is another P2P lending platform. You can borrow up to $40,000 for debt consolidation, with a loan term of between two years and five years.

Prosper charges an origination fee of between 2.4 percent and 5 percent of your loan amount. The interest rate range is between 6.95 percent and 5.99 percent APR, depending on your credit profile.

Here’s a full list of the best personal loans of the month. Insert your personal information and loan requirements to find the lending partners that suits you best:


Debt settlement is one of those concepts that works better in theory then it does in reality. Every year, tens of thousands of people sign up for debt settlement programs, but the failure rate is high.

You’re much better off to go with a debt consolidation loan if you can qualify. That will get you out of debt in just a few years, without hurting your credit. If you’re simply looking to get out of a small amount of high interest credit cards, a balance transfer credit card may be the better answer.

But if your debts are very large, and you completely lack the financial resources pay them back, the best strategy is to discuss bankruptcy with a bankruptcy attorney.

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About the author

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Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed “slash worker” – accountant/blogger/freelance web content writer – on Out of Your He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides “Alt-retirement strategies” for the vast majority who won’t retire to the beach as millionaires. He also frequently discusses the big-picture trends that are putting the squeeze on the bottom 90%, offering work-arounds and expense cutting tips to help readers carve out more money to save in their budgets – a.k.a., breaking the “savings barrier” and transitioning from debtor to saver. He’s a regular contributor/staff writer for as many as a dozen financial blogs and websites, including Money Under 30, Investor Junkie and The Dough Roller.