7 Things Most People Don't Understand About Debt Settlement

If you've looked into debt relief, you've probably come across mentions of debt settlement once or twice. Getting rid of debt for less than you owe sounds great in theory—but it can be hard to tell the facts from the misconceptions.

Learning the truth about debt settlement is key to determining whether it's the path you want to pursue. Let’s look at how it works, and whether it might be a good fit for you. 

Here are seven of the most common things people don't understand about debt settlement.

1. It's a Legitimate Debt Relief Strategy

Debt settlement is a process in which you (or a professional debt settlement company working on your behalf) negotiate with your creditors to get them to accept less than what you owe and forgive the rest of the debt. This is a legitimate debt relief practice that could let you legally get rid of debt without paying the full amount.

Creditors will often negotiate if they're afraid they might not get money from you otherwise. For example, if you declare bankruptcy, they might get nothing. By taking your offer, they get back at least some of what you owe.

Debt relief works best when you can show financial hardship that makes it impossible for you to repay your debts in full. This might be anything from job loss to a major illness or injury that impacted your income.

2. It Usually Works Only on Unsecured Debts

Debt settlement generally only works on unsecured debts—debts that are not backed by collateral (like a home or car) that the creditor can seize and sell to get its money back. This includes most personal loans, credit card debt, and medical debt, to name a few. 

In some cases, it may also be possible to settle previously secured debts, such as a deficiency balance. For example, you can't settle a secured auto loan. But if the vehicle is repossessed and sold for less than you owe, creating a deficiency balance, you might be able to settle that balance for less than the total.

3. It Could Significantly Reduce Your Debt

How much you can settle your debt for depends on who you owe, how much you owe, and your overall financial situation. If the lender agrees, you could settle your debt for significantly less than the balance owed. This could help you put your debt behind you more quickly. Then you can focus on rebuilding your credit and a solid financial foundation.

4. You Can DIY Debt Settlement

It's entirely possible to negotiate with your creditors to settle your debts on your own. This could be the right approach for you if you're comfortable making offers to your creditors yourself, and you want to avoid settlement fees.

For those who prefer a little support, a company like Freedom Debt Relief could take over negotiations for you. FDR helps you come up with a plan, then reaches out to your creditors with offers. You're in charge every step of the way, and no agreements are finalized without your approval.

5. It May Not Affect Your Tax Bill If You're Insolvent

When you settle a debt for less than you owe, the rest of the debt gets forgiven. The IRS considers forgiven debt to be the same as income for tax purposes, so you typically need to pay income taxes on forgiven debt. 

You might be able to avoid the extra taxes if you can show you were insolvent at the time the debt was forgiven. Insolvent means your total liabilities (debts) exceed the total value of your assets. 

In either case, it's smart to consult a tax professional before you agree to a settlement offer.

6. It's Not a Get-Out-of-Debt-Free Card

While many creditors negotiate debts, they're under no obligation to do so. Some would rather wait longer to get the full amount they're owed, as is their right. Even if a creditor agrees to settle, you'll still need to repay at least some portion of your debt (and potentially some extra taxes). Additionally, if you stop payments to save up for settlement and show your creditors you can't afford your debts, your credit score is likely to take a big hit. If you're already behind, however, the extra credit score damage could be negligible. You'll also likely have an easier time rebuilding credit if you're not dealing with unmanageable debt.

Keep in mind as well that debt settlement is a process. It takes time to save up money for negotiations. You must be patient and stay the course, often over months or even two or more years, to realize the benefits from it.

7. Debt Settlement Is One of Several Debt Relief Options

You have plenty of other options if debt settlement doesn't feel like the right fit for you. Some of the most common are.

DIY debt repayment strategies

The debt snowball and debt avalanche methods are DIY strategies for paying off multiple debts. You make the minimum payment on all your debts every month. Then you put any extra cash toward the debt with the smallest balance (snowball method) or highest interest rate (avalanche method) until it's paid off. Then, you move onto the next debt, adding to its minimum payment the amount you were paying on the first debt.

Debt consolidation loan

A debt consolidation loan is a new loan you take out to pay off existing debts. This could result in smaller monthly payments and less interest overall, though it depends on your credit and loan terms. This method also gives you fewer monthly payments to track.

Debt management plan (DMP)

Credit counselors can help you set up a debt management plan (DMP). They may negotiate with your creditors to get lower interest rates and waived fees, but you typically have to close your accounts as part of the agreement. You make a regular monthly payment to the credit counselor, and the company then disburses it to your creditors.

Bankruptcy

Bankruptcy is a legal way to get rid of eligible unsecured debts. Chapter 7 bankruptcy could remove your debts in as little as a few months, though you usually have to give up some or all of your nonexempt assets. Chapter 13 bankruptcy lets you keep your possessions, but it requires you to make payments to your creditors for three to five years. Consult a bankruptcy attorney to see if either option is right for your situation.

It's worth exploring every option before deciding which is right for you. You might also employ more than one method to get yourself out of debt. For example, maybe you use the snowball method to knock out a few of your smaller debts, then switch to debt settlement for the rest. The key is to find the strategy or strategies that work for you and stay consistent.