7 Risks of Debt Settlement

1. Damage to Your Credit Score

Debt settlement requires you to withhold payments to your creditors while you attempt to negotiate a settlement for less than you owe. You may choose to work with a debt settlement company and have someone negotiate on your behalf, or you can negotiate on your own. If you choose to work with a debt settlement company, they will collect a payment from you and deposit it into a savings account they'll tap when they attempt to settle your debt.

Withholding debt payments has serious consequences to your credit, though. Your creditors will likely report these withheld payments to the credit bureaus as late, which damages your credit scores. Since payment history is the biggest factor in calculating your credit score, accounting for 35% of your FICO^® Score^Θ, any derogatory mark in this category can bring down your score.

2. Potential Charge-Offs

The debt settlement process can take up to four years. And the more time you spend negotiating a settlement amount and withholding payments, the more likely it becomes that your account could be charged off during the process.

A charge-off is a negative entry on your credit report. Creditors charge off accounts when they no longer expect you to make your missed payments and repay your debt. Charge-offs stay on your credit report for seven years from the date of the first missed payment, also called the initial delinquency date, and can affect your scores negatively during that time.

3. More Financing Challenges Later On

Because late payments and charge-offs stay on your credit report for seven years, they can have a notable impact on your borrowing prospects for that entire period (though their impact can lessen over time). Lenders may be hesitant to loan you money due to the presence of late payments on your report.

Your credit report also specifically notes if you settle for less than the full amount owed, and settled accounts are considered a negative entry because they mean you didn't pay a debt as agreed. Again, this can impact your borrowing prospects for the long haul, making it hard to get things like mortgages, car loans, credit cards and other borrowing products—or costing you more in interest.

Learn more: How Long Do Settled Accounts Stay on a Credit Report?

4. Increased Costs

On top of the financial penalties associated with debt settlement, you may also face increased costs. Debt settlement companies typically charge 15% to 25% of the total debt enrolled, plus extra fees based on how much debt was forgiven in some cases. Debt settlement companies may also charge you fees for administering the savings account used to save up your settlement amount.

Once these costs are added up, you could end up paying more than you owed—even though your settlement amount was less than your total debt to begin with.

5. Tax Implications

When part of your debt is forgiven during the debt settlement process, this forgiven balance is viewed by the IRS as taxable income, so you will owe taxes on that amount—just as if you had earned that money at a job.

For debts of $600 or more, you will receive a 1099-C from your creditor. This is a Cancellation of Debt form that they'll also send to the IRS, letting them know you owe taxes on that forgiven amount. If you don't report the forgiven debt on your annual tax return using the Schedule 1: Additional Income and Adjustments portion, the IRS may contact you about it.

Learn more: Tax Implications of Settling Your Debt

6. Getting Scammed

Debt settlement scams target consumers in need of debt help. They may be after your private information to steal your identity, or they may ask for upfront payments without ever actually settling your debt.

Some pose as government programs, or they can come as robocalls. Even websites that look legitimate can be scams, so be extra careful about where you seek debt help.

Signs that may indicate a debt settlement scam include:

• Large upfront fees, which legally cannot be collected prior to settlement
• Unsolicited calls, texts, emails or robocalls
• Promises to remove negative but accurate information from credit reports
• Guarantees that they can remove your debts entirely or stop all collection calls or lawsuits
• Companies that encourage you to stop all communication with creditors

Learn more: Signs of Debt Settlement Scams to Watch For

7. Debt Settlement Is a Gamble

There's no guarantee that the debt settlement process will work, and creditors aren't required to work with you to settle your debt. You could spend months or years missing payments only to have your debt negotiations ultimately turned down. At that point, you may be in worse shape than when you started or need to explore more drastic options, like bankruptcy.

Learn more: How to Negotiate Credit Card Debt Settlement Yourself

Is Debt Settlement a Good Idea?

Debt settlement has significant drawbacks and risks. It can hurt your credit and have long-term consequences for your finances, but it may still be an option to consider for certain consumers.

For example, if you're already significantly behind on your payments or your credit score is already in poor shape, then pursuing debt settlement may be a valid strategy. If you're unable to qualify for other options, like debt consolidation or a debt management plan, you may also want to consider settlement before a lawsuit or filing for bankruptcy.

Learn more: Is It Better to Pay Off Debt or Settle It?

Safer Alternatives to Debt Settlement

Debt settlement isn't the only option if you're overwhelmed by your debts. In fact, other options may be better for your credit and long-term financial prospects.

Some alternative options to consider include:

• Using a debt payoff strategy: The debt avalanche and debt snowball payoff strategiesare popular options for paying down debt. With the debt avalanche approach, you pay off the highest-interest-rate debts first, while the snowball focuses on the lowest balances first. This helps keep you motivated with smaller wins.
• Credit counseling: A certified credit counselor can give you guidance on how to pay off your debts and protect your credit while doing so. Make sure to use a counselor accredited by the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America (FCAA).
• Debt management plan: Credit counselors may suggest a debt management plan, in which they negotiate a payment plan and lower interest rates so you can pay your debts in full, usually over three to five years. Credit counseling agencies typically charge low fees to set up and maintain a debt management plan, such as an initial setup fee of about $25 to $75 and a monthly fee of $20 to $75.
• Debt consolidation loan: To save on high-interest credit card bills, you could consider a debt consolidation loan. This is when you take out a loan at a lower rate than what you're paying on your credit cards and other debts, and then use the funds to pay off your higher-interest balances. This allows you to pay back the loan at a lower interest rate and with just one monthly payment instead of many, which saves money and helps with cash flow. However, you likely need a good credit score to access a debt consolidation loan, so the sooner you can apply when dealing with debt, the better.
• Balance transfer card: A balance transfer card is a credit card you can transfer existing card balances onto. You will pay a transfer fee of 3% to 5%, but often receive a lower interest rate or even an introductory 0% interest rate if you have a qualifying credit score. Be careful to note any expiration date on promotional interest rates, as you'll want to pay off your balance or transfer it to a new card before your rate jumps to the card's ongoing rate.

Keep in mind that you can negotiate with your creditors yourself too. You can do all the same—and maybe better—debt negotiation tactics that debt settlement companies would do for you. And better yet, you can do it for free. So if you are set on settling debt without working with a debt settlement company, you may be able to save yourself some fees by negotiating yourself.

Learn more: Alternatives to Debt Settlement

Frequently Asked Questions

The Bottom Line

When it comes to debt settlement, the risk to your financial well-being may not be worth the reward of reducing the debt you owe. It could even be more expensive in the long run.

Choosing a safer option like a balance transfer card, working with a credit counselor or getting on a debt management plan may be a better option. Download your credit report for free from Experian to learn more about your current debts and get started on your repayment journey today.