Is debt settlement worth it?

Debt settlement means a creditor agrees to take less than you owe, usually after you have stopped paying for months. It can cut what you pay, but fees, growing balances, taxes on the forgiven amount and serious credit damage often eat much of the savings.

Creditors don't have to agree

No law forces a lender to settle. Some won't deal with a settlement company at all, and companies often settle small debts first while interest and fees keep growing on the big ones.

Your credit takes a hit

Settlement programs usually tell you to stop paying your creditors and save into a special account instead. Each missed payment can be reported, and the accounts often end up charged off or in collections.

You can still be sued

While you are saving up, creditors and collectors can keep calling and can file a lawsuit. A settlement company can't stop that.

The forgiven part may be taxed

The IRS generally treats canceled debt as income. An exclusion applies if you were insolvent, meaning your debts were larger than everything you owned, just before the debt was canceled.

How a settlement program works

You sign up and the company tells you to stop paying the cards it will negotiate. Instead, you deposit a monthly amount into a dedicated account held by an independent company. The money in that account is yours, and you can withdraw it at any time without a penalty.

Once enough builds up, the company offers a lump sum to one creditor. If the creditor accepts and you approve the deal, the money is paid out and the company takes its fee for that debt. Then it moves on to the next one. Programs often run for several years.

What it really costs

Add four things. The settlement payments. The company's fee, which is usually a share of the debt it resolves or a percentage of the amount you save. The interest and late fees that pile on while you are not paying. And any income tax on the forgiven amount.

Under FTC rules, a debt settlement company can't collect its fees before it settles your debt, and it can charge only part of its full fee each time it settles one account. Before you sign up, it must tell you its fees, how long results will take and the risks of stopping payments. A company that wants money upfront is breaking the rule or is a scam.

Settlement versus a debt management plan

A debt management plan, set up through a nonprofit credit counseling agency, works differently. You make one monthly payment to the agency, and it pays your creditors. Creditors often agree to lower interest rates and drop some fees, and you repay the full balance, often over about 4 years or more.

You usually have to close the cards in the plan, but you keep paying on time, which protects your credit far better than months of missed payments. The trade-off is that you pay back everything you borrowed.

How to settle a debt yourself

If an account is already in collections and you have a lump sum, you can make the offer yourself. Start low, make clear it is a one-time payment and ask for the agreement in writing before you pay.

Pay from an account the collector can't reach later, such as a cashier's check or a one-time payment, rather than giving ongoing access to your checking account. On a very old debt, check your state's statute of limitations first, because a payment can restart the clock in some states.

When settlement makes sense

Settlement can fit when your accounts are already badly behind, you can't afford a debt management plan payment, you can build a lump sum and bankruptcy is not right for you. Compare all three with real numbers before you decide.

If you have no realistic way to repay and no money to save, a free consultation with a bankruptcy attorney is worth an hour. Bankruptcy also hurts your credit, but it can stop lawsuits and wipe out debt that settlement would take years to reach.