How Does Debt Settlement Work?

These days, nearly everyone has debt of one kind or another. Home mortgages, car loans, credit cards, and student loans are a fact of life in the current American financial landscape. While most of us manage to stay on top of our debts and keep up with our payments, the harsh reality is that sometimes the debts grow too large, or life happens and you suddenly find yourself in a position where repaying all that you owe is impossible. When that happens, it may be time to look into settling some of your debts. While not an ideal solution, debt settlement is sometimes the only way to avoid bankruptcy.

Most people, though, don’t understand how debt settlement works. This article is intended to give you a basic introduction to the concept.

What Is Debt Settlement?

how does debt settlement work

Find Out if Debt Settlement is Right for You

Simply put, debt settlement is when your creditors accept less than the full amount they are owed in order to avoid the total losses they would face if you declare bankruptcy. This amount is usually a relatively small (sometimes very small) percentage of the total amount. The amount of the settlement is arrived at after a process of negotiation that is usually lengthy and often contentious. Once you pay the settlement amount, a notation is made in your credit report, and the debt is marked as paid.

It’s worth noting, too, that not all debts are eligible for settlement. Secured debts – home loans, car loans, etc. – cannot be settled. If you cannot pay your mortgage or your car payment, the property is repossessed or foreclosed on by the creditor in order to recoup their losses. Settlement is for unsecured debt like credit cards and personal bank loans. With this kind of debt, there is no property for the creditor to take, and so they have to use other means – including settlement, and sometimes lawsuits or wage garnishments – to get their money back.

Why You Settle

One of the central aspects of the question “How does debt settlement work?” is the question “Why would I need to settle?” The simple answer is: to stave off bankruptcy. Debt settlement is not a process you undertake because you don’t want to have to make payments any more, nor is it a “get out of debt free (or cheap)” card. It’s a last resort. It’s a final stopgap measure to keep you out of bankruptcy court.

Why Creditors Settle


It may seem counter intuitive for creditors to settle. All things being equal, it would seem to be better for them to persist in attempting to collect the full amount of your debt. After awhile, though, too many bad debts in their records becomes a problem for them. Additionally, the longer an account is delinquent, the more difficult recovering the full amount becomes decreasingly likely. When you get to that point settling starts to make sense. After all, something is always better than nothing. When an account becomes sufficiently delinquent it becomes better for your creditors to get something back so they can mark your account as paid and clear it out of their record books.

How Creditors Behave

While your creditors will be willing to settle if they have to, they do not want to. They would prefer, of course, to recoup all of their money, rather than have to settle for only getting some of it back. To that end, they will often take measures that are unsavory, even mean, in order to get you to pay in full. One of the first things they will do is send your account to a collections agency. These agencies often engage in highly intimidating practices, including constant phone calls, rude and abrasive behavior, and threats to garnish your wages or even sue. Usually, though, these sorts of threats are meant solely to intimidate, and they will not actually sue you, provided you remain reasonable and continue to make good faith efforts to settle.

What Debt Settlement Means For Your Credit

One of the questions you need to ask when you start asking “How does debt settlement work?” is “How will it impact me in the future?”    The simple answer here is that debt settlement will all but ruin your credit. Much like a bankruptcy, debt settlements have a strong and long-lasting negative impact on your credit score. To start with, before you can settle your accounts, you have to be delinquent in your payments. Missed payments, naturally, reflect negatively on your credit report. The longer you go without making regular payments, the harder those missed payments. Additionally, having a debt referred to collections lowers your score. Finally, a settled debt is marked differently in your credit report than a debt that is paid in full, and lowers your score.

In short, settling debt will send your credit rating tumbling straight to the basement, and repairing your credit after a debt settlement will be a long, hard slog. As bad as it is for your credit, though, bankruptcy is even worse, and sticks around for longer.