What People Get Wrong About Debt Settlement

Debt settlement companies promise to cut what you owe. Regulators describe a process that can add fees, lawsuits and taxes long before any relief arrives.

This guide is general information for borrowers in the U.S., not financial or legal advice. Lending laws differ by state and change over time; check with your state's financial regulator or a nonprofit credit counselor about your situation.

Key points

1. Debt settlement companies often tell you to stop paying creditors, which adds late fees and penalty interest and can lead to a collection lawsuit.
2. Under an FTC rule effective October 27, 2010, for-profit companies selling debt relief by phone cannot collect fees before settling at least one of your debts.
3. Forgiven debt is generally taxable income. A creditor that cancels $600 or more must send you a Form 1099-C.
4. Settlement plans rely on months of missed payments, which can drag your credit scores down and make new credit harder to get.
5. Negotiating directly with creditors or working with a nonprofit credit counselor costs far less and carries fewer risks.

Debt settlement companies advertise a simple trade: stop paying your creditors, let a professional negotiate, and pay less than you owe. Regulators describe a messier outcome. The Consumer Financial Protection Bureau warns that settlement may leave you deeper in debt than when you started, and the Federal Trade Commission and state enforcers together have brought more than 250 law enforcement actions against debt relief providers. These are the mistakes people make when weighing the option, and the steps worth trying first.

Mistake 1: Assuming Settled Debt Disappears for Free

A settlement reduces a balance. It does not erase the cost of getting there. Most settlement firms tell customers to quit paying their credit card bills, and each missed payment brings late fees, penalty interest and other charges. If you go over your credit limit, extra fees can pile on top.

The company may not settle everything, either. When only some accounts get settled, the penalties building on the unsettled ones can wipe out the savings on the settled ones. Fees take another bite: some companies charge up to 25 percent of your pre-settlement debt for each completed settlement. Added together, the discount can be far thinner than the pitch suggested.

Mistake 2: Believing a Company Can Stop Collectors and Lawsuits

Settlement companies often tell customers to stop paying and stop talking to creditors altogether. That silence protects the company’s negotiating position, not yours. If you stop paying, creditors will likely step up collection efforts, and working with a settlement company can end in a debt collection lawsuit filed while you are still saving up the funds to settle.

Ignoring a collector does not make the contact stop, no matter who advises it. Your real protection comes from law. The Fair Debt Collection Practices Act limits what collectors can say and do, and you have the right to tell a collector to stop contacting you. If someone calls about a debt you do not recognize, read our guide to debt collectors, fake collectors and loan scams before you pay anyone.

Mistake 3: Paying Big Fees Before Any Debt Is Actually Settled

Under an FTC rule that took effect October 27, 2010, companies that sell debt relief services over the telephone cannot collect a fee before they settle or reduce your credit card or other unsecured debt. A fee can be collected only after three things happen: the company settles or changes the terms of at least one of your debts, you have agreed to a written settlement agreement or similar deal with the creditor, and you have made at least one payment to the creditor under that agreement. The rule also covers calls you make to these firms in response to their ads, and it applies to companies that falsely claim nonprofit status.

If a company requires a dedicated account for your fees and settlement savings, you have the right to withdraw at any time without penalty and get back unearned fees. The FTC and state enforcers have brought a combined 259 law enforcement actions against debt relief providers. In one case, the FTC alleged a company did not contact creditors until customers had paid an administrative fee in full, which could take six months or more. Customers later received $3.7 million in refunds through a separate Texas Attorney General action.

Mistake 4: Forgetting Forgiven Debt Can Be Taxable Income

This one surprises people at tax time. If a creditor forgives part of what you owe, the IRS generally treats the forgiven amount as taxable income. You must report it for the year the cancellation happened, usually as ordinary income on your federal return.

Creditors that cancel a debt of $600 or more are required to send you a Form 1099-C showing the amount canceled and the date. You still have to report any taxable canceled debt even if the form is wrong or never arrives, and even if the amount is under $600. Exceptions exist. Discharged amounts may not be taxable if you were insolvent, if the debt was canceled in bankruptcy, or in some cases involving qualified principal residence indebtedness. A tax professional can tell you which exception applies to your situation.

Mistake 5: Expecting Your Credit to Bounce Back Quickly

Settlement plans are built on missed payments, sometimes many months of them, and payment history carries heavy weight in credit scoring. The CFPB states plainly that using debt settlement services can lower your credit scores and make it harder to get credit down the road. Industry observers note that people who finish these programs often end with scores below 600, a range lenders treat as subprime.

Rebuilding takes consistent on-time payments afterward, not a quick reset. If short-term loans are also part of your history, our guide on do payday loans affect your credit explains how reporting and defaults work.

What to Do Instead: Cheaper and Safer Paths First

Before you pay a settlement company, try the options regulators recommend. Contact your creditors yourself and ask for help. Some will accept lower minimum monthly payments, waive certain fees, reduce your interest rate, or change your due date to line up with when you get paid. A nonprofit credit counselor can advise you on managing money and paying off debt, and credit counseling organizations exist to help you avoid these problems in the first place.

Also look at why the shortfall exists. If bills are crowding out debt payments, our guide to help to look for before you borrow covers utility, rent and medical assistance. If you need a small amount of short-term credit, compare credit union payday alternative loans, which are built to cost less than high-fee products.

Be careful

Walk away from any company that charges fees before settling a debt, guarantees it can make debt go away, promises a fixed percentage cut in what you owe, claims a “new government program” will erase credit card debt, or tells you to stop communicating with your creditors.

Related guides

• How Payday Loans Work, and What They Really Cost: the full cost picture for short-term borrowing before you commit to any product.
• Do Payday Loans Affect Your Credit? How Reporting and Defaults Work: how unpaid short-term loans reach your credit report and what that means for your score.
• Help to Look for Before You Borrow: bill, rent, food and medical assistance that can shrink the shortfall driving the debt in the first place.

Common questions

Is debt settlement legal?

For-profit companies can sell these services, but a federal rule bars companies that sell debt relief over the telephone from collecting fees before they settle or change the terms of at least one of your debts, you have agreed to a written deal, and you have made at least one payment under it.

Will I owe taxes on debt that is settled?

Generally yes. The IRS treats canceled debt as taxable income for the year the cancellation occurred. Exceptions exist for insolvency, bankruptcy and certain home mortgage debt.

Can a settlement company stop collectors or lawsuits?

No. Stopping payments is what often invites both. Your protections come from laws like the Fair Debt Collection Practices Act, not from a private company.

What is a cheaper first step?

Contact your creditors directly. Some will accept lower minimum payments, waive certain fees, reduce your interest rate, or move your due date to match your pay schedule.