What Is Debt Settlement? How It Works and What It Really Costs

Between rising prices and higher interest rates, it's no surprise that many people are struggling. In 2025, almost 20% of families reported being behind on loan payments, up from about 12% in 2022 and the highest level since 2010, according to the Federal Reserve.

Debt settlement can reduce what you owe, but it usually means falling further behind first. Settlement companies typically tell you to stop paying your creditors while you save up, and that can result in late fees, collection calls, and even lawsuits before your debt is settled.

What is debt settlement?

Debt settlement is a negotiation process where you attempt to get your creditors to agree to accept less than the full amount that you owe. There are two main approaches: handling the negotiations on your own, or hiring a debt settlement company.

Negotiate on your own

You can contact your creditors on your own and propose a settlement. Typically, you're more likely to be successful if you have a lump sum you can offer as an upfront payment. The do-it-yourself approach is cheaper, since you don't have to pay fees, but it requires patience, time, and not all creditors will work with you.

Work with a debt settlement company

Debt settlement or debt relief companies negotiate on your behalf for a fee. It’s usually based on the amount of debt they settle or save you, averaging 22% of enrolled debt, according to a study from industry trade group Association for Consumer Debt Relief, so get the exact percentage in writing. A company can’t charge you before it’s settled at least one of your debts.

Read more >> How Does Debt Relief Work?

What is the debt settlement process?

1. You stop paying your creditors. Creditors rarely settle accounts that aren’t already behind on payments, and so settlement companies typically have you stop paying. While you do, late fees and interest add up, your accounts can go to collections, and creditors may sue you.
2. You save in a designated account. You make monthly deposits into an account in your name. The money is yours, and you can withdraw it without penalty, though the account may charge fees. Once enough savings builds up, such as 20% of your enrolled debt, the company starts making offers to your creditors.
3. You wait for an agreement. Creditors don’t have to agree, some won’t negotiate at all, and the process can take years. When a creditor accepts, get the terms in writing before you pay.

Because stopping your payments can lead to legal trouble, talk with a nonprofit credit counselor before you enroll. A counselor can compare settlement with a debt management plan that doesn’t require missing payments.

What types of debt are eligible for settlement?

Debt settlement is only for unsecured debt, meaning debt that doesn't have any form of collateral. Credit card bills and personal loans are the most common forms of debt that qualify for settlements.

Most companies set minimum amounts of debt they’ll accept. For example, they may only work with clients who have at least $7,500 in unsecured debt.

Secured debt, such as a home loan or car loan, isn't eligible for debt settlement. Because these loans are backed by collateral, a home can go into foreclosure and a car can be repossessed to recoup their money, rather than negotiating a settlement.

Read more >> What Is Debt Forgiveness? Who Qualifies and What It Costs

How does debt settlement affect your credit?

Settlement usually means several months of missed payments first, and payment history is the biggest factor in your FICO Score. How far your score falls depends on where it starts, and higher scores tend to drop by more. Missed payments stay on your credit report for seven years, and settling for less than you owe can also show up.

Read more >> The Importance of On-Time Payments in Building Credit

Pros and cons of debt settlement

Pros

• Can reduce what you owe. After fees, clients saved an average of 30% on each account they settled, according to an Association for Consumer Debt Relief study. (That figure leaves out the 28% of clients who never settled an account, and it doesn’t account for taxes.)

Cons

• Damages your credit. The impact of debt settlement on your credit can be substantial, and it will remain on your credit report for seven years.
• Forgiven debt can be taxed. The amount your creditor forgives generally counts as taxable income, unless you qualify for an exception.
• High fees. Fees can be 15% to 25% of your enrolled debt, depending on the service, which reduces overall savings.
• Not available in every state. Some states restrict debt settlement companies or cap their fees. Check with your state attorney general for laws where you live.

Read more >> Debt Cancellation: How It Works and What It Costs You

Debt settlement alternatives

• DIY debt repayment. DIY approaches like debt snowball or debt avalanche paydown methods can be useful for smaller or secured debts.
• Debt consolidation. If you have good credit, a debt consolidation loan combines your debt into one loan, typically at a lower overall rate.
• Debt management plan (DMP). If you're overwhelmed by your debt, a nonprofit credit counseling agency can help structure a repayment plan or negotiate fee waivers and lower rates.
• Bankruptcy. Bankruptcy can eliminate or restructure many debts. It’s a complex legal process that affects your credit for years, and not all debts and property qualify, depending on your state and the chapter you file.

Read more >> How to Negotiate Credit Card Debt With Your Creditor

‍Talk to somebody before you decide. If you’re considering bankruptcy, talk with a licensed attorney or nonprofit credit counselor. Filing too soon can cost you the fee with no discharge. Legal aid offices help free of charge if you qualify by income, and NFCC counseling is free or low cost at 800-388-2227.

Bottom line

Debt settlement can cut your balances, but it can result in missed payments, fees, and the risk of being sued. Before you enroll, a nonprofit credit counselor can tell you whether a debt management plan can help you reduce what you owe with less damage.

If your debts are already in collections or charged off, there's nothing left to stop paying, and you don't have to hand a company a share of your balance to negotiate. Kikoff AI Debt Negotiation helps negotiate offers on your behalf, making it easier to manage debt with less hassle and more confidence, no membership required. Settling for less than the full balance can affect your credit, so weigh each offer before you accept.