Debt Settlement Pros and Cons: Is It Worth It?

Debt settlement is a personal decision. Here's how to weigh the pros and cons for your situation. 

Debt settlement pros and cons at a glance

Before diving into details, here's the good and the bad in plain terms:

The long and the short of debt settlement is this: It could be worth it—but only if your situation is severe enough to justify the costs.

When debt settlement could be worth it

Settlement isn't for everyone. But it could make sense if most of these apply to you:

You might be a good fit if:

• You have $7,500+ in unsecured debt (credit cards, medical bills, personal loans)
• You can't keep up with your minimum payments
• Your credit is already damaged from late payments or collections
• You've looked at other options (DMP, consolidation) and they don't fit
• You've experienced financial hardship like job loss or serious injury
• You can commit to two to four years of the program
• You could handle a lawsuit if a creditor sues (not common, but possible)

The more boxes you check, the more settlement starts to make sense. If you only check one or two boxes, other options may be a better fit for your situation.

When debt settlement probably isn't worth it

Settlement has real costs and it isn't a painless process. If any of these describe you, it's probably not the right path:

Settlement likely isn't worth it if:

• You could afford minimum payments with some budgeting
• Your credit score is still good and you want to protect it
• Your debt is mostly secured (car loans, mortgages)—these usually can't be settled
• You have student loans or tax debt—these typically can't be settled either
• You need access to credit soon (buying a home, car loan)

Debt settlement can help people who are overwhelmed by debt and have few options, but it shouldn't be the first thing you try. If you can afford a DIY debt payoff method or have the credit to consolidate your debt with better terms, that may be a much better option in the long run.

The risks you need to know

Every settlement company should tell you these risks. Many don't—and you should avoid companies that aren't transparent about potential consequences. 

Here's what you could experience during debt settlement.

Damage to your credit

Missed payments hurt your credit scores. If you choose to stop making payments to creditors when you enroll, this will cause damage to your credit. A delinquent account can stay on your credit report for seven years from the first missed payment.

The exact impact on your credit will depend on what your credit looks like to start. If your credit is still good, that first missed payment will probably hit pretty hard. If your credit is already damaged from missed payments, additional missed payments likely won't cause a big score drop.

Risk of a debt lawsuit

Creditors have the right to sue you to collect unpaid debts. And that right doesn't go away just because you enroll in a debt relief program. In other words, creditors can still sue you while you're saving up for a settlement. Debt lawsuits aren't super common, but they do happen—especially for larger balances. A reputable company will tell you this upfront.

Taxes on forgiven debt

Forgiven debt is considered income by the IRS. As such, you may need to pay income tax on any debt that's been forgiven. You'll even get a 1099-C form if your forgiven debt exceeds $600. 

There is one potential exception: If you're insolvent, you may not owe taxes on the forgiven amount. Insolvent means your total debts exceed your total assets. Many people enrolled in a debt settlement program are likely eligible for the insolvency exception.

Settlement fees

Settlement companies typically charge 15-25% of your enrolled debt as a debt settlement fee. By law, they can't charge upfront settlement fees. In fact, a settlement fee can't be charged until an agreement is reached, you've approved it, and at least one payment has been made to your creditor. 

If a company asks for debt settlement fees before producing results, walk away.

No guarantees of success

There is no guaranteed amount you'll save on your debt—or that you'll save anything at all. Creditors aren't required to negotiate. Some won't agree to any kind of settlement. Others may be open to settlement but not budge on how much they'll accept.

A settlement company can't promise a specific outcome. If they do, that's a huge red flag.

Other options to consider

Settlement is most appropriate for people with unmanageable unsecured debt who can't afford to repay their full balance due to financial hardship. If that's not you, consider:

• Debt management plan (DMP): A nonprofit credit counselor will try to negotiate with your creditors to reduce your interest rates and potentially waive late fees. You pay back 100% of what you owe, typically over three to five years. A DMP is generally better for your credit than settlement. Check out debt management plans to learn more.
• Consolidation loan: This is when you use a new loan to pay off multiple debts, ideally at a lower interest rate than you're currently paying. You'll still pay back 100% of your debt, but you'll only have one monthly payment, and you could reduce your monthly payment if you qualify for better terms. Consolidation loans typically require at least fair credit.
• Bankruptcy: If you're overwhelmed by unsecured debts and can pass the means test, Chapter 7 could discharge qualifying debt in three to four months. Talk to a bankruptcy attorney to learn if you're a good candidate for Chapter 7 bankruptcy.

For a broader comparison, see debt relief options.

Bills Action Plan

Step 1: Add up your unsecured debt. This includes credit cards, medical bills, and personal loans. Most debt relief companies require $7,500 to $10,000 in unsecured debt to enroll.

Step 2: Run through the checklists above. Did you check off a lot of the boxes in the Worth It list? This could be a sign you're looking in the right place.

Step 3: If settlement fits, research companies carefully. Avoid any company that charges upfront debt settlement fees or guarantees specific results. Look for accreditation with the ACDR or IAPDA, and check out reviews from real clients to see if the company is reputable.