Solving a Debt Dilemma with Debt Settlement

By Stacy Johnson. Last updated 7 February 2010. 7 comments

Debt settlement companies are advertising a lot these days on TV, radio and online: you've probably got debt settlement Google ads around this article right now. If you're in a jam, they might sound tempting. Should you bite? I’d be super-careful

Here’s an excerpt from my latest book, Life or Debt 2010, about what debt settlement is, how it works, and whether it’s a good idea.

Imagine that I owe you some serious money, say 10 grand. I faithfully made payments to you when I first borrowed the money five years ago, but since then I've lost my job and moved away. Now the payments have stopped. You've called me over and over, but despite your harassment, you haven't gotten a payment from me in over a year.


Then out of the blue one day I call you up and say, “Gee, I’m really sorry about being such a jerk. But I'm still having trouble making ends meet. Here's what I propose: I'll borrow four grand from some other nitwit and send it to you today. If I do that, will you call it even? If you won’t accept that, I'll be forced to file bankruptcy and never pay you back at all.


You think it over and realize that $4,000 is better than nothing. So you take the money, remove me from your Christmas card list and head on down the road.


That’s debt settlement. It’s offering your creditor a lump sum of less than you owe to satisfy a debt.


There's nothing preventing you from doing this all by yourself. You can call the bank and offer to pay them less than you owe. Feel that you're not the best negotiator? You could ask a lawyer to do it for you: a bankruptcy lawyer would be a good choice. But there's another problem: you don't have the lump sum you need to even make an offer. There's where a debt settlement company comes in.

I recently visited a debt settlement company and interviewed both the owner and one of their clients. Watch the result below, then I"ll give you the back story on the other side.

As you just saw in that news story, the way most debt settlement companies work is to collect monthly payments from you every month. Then, after you’ve accumulated enough, they’ll make a settlement offer to the credit card company or other creditor on your behalf. So if you’re making payments to the credit card company now, the debt settlement company wants you to stop doing that and send it to them instead.

Good strategy? Well, if you’re not keeping up and have no hope of making your payments, it might seem logical. Furthermore, you might feel the bank deserves it, especially if part of the reason you can't keep up is because the bank's made your situation hopeless by jacking up your rate to 36% and piling on thousands of dollars in penalty fees.


The first is that you're thoroughly trashing your credit history and score by failing to make payments, not to mention ultimately paying less than you owe. You’d be pissed if I did that to you; banks are pissed when you do that to them. And they hit your credit score accordingly. The cost to your score, according to Fair Isaac (the company behind most credit scores), is 45-125 points. That’s a big hit, and one that's going to cost you big when you next need to borrow money.

What type of credit card are you interested in?
How much do you spend per month?
Do you carry a balance?

The second problem is that when you settle a debt for less than you owe, you’re also creating an income tax liability. In the example above, when I paid you $4,000 to settle a $10,000 debt, the $6,000 I didn’t pay is what’s called a forgiven debt. And forgiven debts are taxable income. In other words, if you legally get away with $6,000 worth of debt, to the IRS that’s like earning $6,000; and that in turn could mean a bigger tax bill — $1,000 - $2,000 bigger, depending on your tax bracket. Add a thousand dollars to the $4,000 you paid to settle that $10,000 debt and now you're paying $5,000. But it doesn't end there.

The third reason I’m not enamored of debt settlement companies is the fees they charge: typically 15%. Not of the amount you actually paid to settle the debt, but the amount you owed. In our $10,000 example, that’s adding another 15% of $10,000, or $1,500. So if we settled for $4,000, paid $1,000 in income taxes and $1,500 to the debt settlement company, now our total tab has ballooned by more than 50% to $6,500.

To me, $1,500 seems a high price for doing something that’s pretty easy: calling a bank and offering them less than what you owe. That’s probably why the debt settlement industry advertises so heavily — they're making a bunch of money.

And one final issue with debt settlement is it's largely unregulated. And that could mean serious trouble. Even the owner of the company that I interviewed for my story above said so. As he pointed out, some agencies take major fees up front before they even begin to settle your debt. Some don't adequately disclose the fees or tax ramifications. Some have been charged with simply flat out stealing people’s money. And, as noted above, even ethical ones charge what I consider high prices for work that’s not rocket science.

I’m not going to say you should never, ever deal with any debt settlement company. After all, it’s possible that there’s a really great one out there somewhere. And debt settlement could theoretically be appropriate for certain people in specific situations.

But you really need to be aware of the risks. The debt settlement industry is under investigation a lot these days. One example is a probe by the New York Attorney General’s Office. Check out the press release they issued about it.

So if you’re going to go down this road, think hard, read the fine print, check with the BBB, state consumer protection agencies, complaint sites and any other place you can think of. And ask a whole lot of questions first.

  • What fees are you going to charge?
  • What taxes might I be responsible for?
  • How is the money I'm sending you protected?
  • How long have you been in business?
  • How long will your program take?
  • Are your fees front-loaded?
  • What happens to my money if I drop out of the program?
  • What happens to my money if you fail to settle the debt for an acceptable amount?

Bottom line? If you can borrow four grand to settle a ten thousand dollar debt, maybe from a relative or something, OK. But paying into a sketchy company for months or years, totally trashing your credit in the process, and paying major fees to do it? Not me.


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Guest's picture

Thanks for explaining how these debt settlement companies work. Two years ago, my credit score was at an all time low because of missed payments and unsettled debts. Not only was I stressed because I was living paycheck to paycheck, but I was constantly hounded by collectors to where I never wanted to answer my phone. I thought about see if a debt settlement was a good idea for me but the thought of paying someone to help me get rid of debt seemed like a bad idea. From researching online, reading blogs like this one and my own hard work, my credit score has been raise almost 100 points and I am $1000 away from being debt free!

Guest's picture

I think you did a huge disservice by not pointing people to reputable organizations such as those non-profits accredited by NFCC (national foundation for credit counseling) and AICCA (Association of Independent Consumer Credit Counseling Agencies)

Guest's picture

He wrote about those yesterday, FYI.

Guest's picture

Let's face it, the debt settlement companies would not be doing this if there wasn't enough money in it for them but there obviously is. I have no problem with that as long as they do a decent job and keep their customers interests at the very forefront of what they do.

Guest's picture

#1 The affects to your credit are short term and not long term. Once the debt is negotiated by a debt settlement company, the creditor agrees to update the credit report, showing a zero balance and stating that the account is paid or "paid as settled"

I went through a debt settlement company and I finished the program 1 year ago, my credit score is 793 and my wife’s is 843. Now our score did go down at the beginning, but after the drop, it continued to increase to what it is today.

#2 Paying taxes on the savings. This can happen, but if you are insolvent then you do not have to pay these taxes. In other words, if you owe more money (overall, including all debts) than you own (your home, auto, etc) and most of American Citizens have more debt than assets since most people's home value is less than what is owed, then all you have to do is go to and download from #982. If you have more debts than assets, then you do not have to pay this tax.

Keep in mind that you have to fill out this form, only if you receive a 1099 from the creditor once the debt is settled.

#3 Fees. Think about this for one second. Every year you pay fees in the form of interest on your debt. If you pay 12% interest on your debts, then you are essentially paying 12% fee every year to your creditors and next year you will pay that fee again and again.

The part you forgot to mention is the 15% fee charged is not an annual fee, it is a one-time fee and doesn't continue. Therefore, if you are in a 3 year debt settlement program, then you can average the fee over three years, which equates to only 5% per year. If your interest rates are higher than 5%, then it clearly makes sense, especially when you do not have to pay back the entire amount.

#4 BBB. If you did your research, you would already know that the BBB is no longer rating debt settlement companies. In fact, one of the VP's of the BBB, has a vested interest in a consumer counseling program which directly competes directly with debt settlement companies. Go to and search for "BBB and debt settlement companies" and you will see that the BBB stopped rating all of the debt settlement companies.

The BBB is not a government agency; they are a private company collecting fees for business being accredited. Because they are not rating debt settlement companies, they are essentially doing the consumer a HUGE injustice, because they are no longer separating the good companies from the bad companies, which is terrible for the consumer. The main function of the BBB is to separate the good from the bad and they are taking the position that all debt settlement companies are bad.

The last thing that no one mentions is financial related. If the banks been collecting payments for the last 5 years, then why does the debtor still owe money. Because the amount being collected by the banks in minimum monthly payments (even if you do not use the cards) will take much longer than 5 years. Typically it is closer to 20+ years and that is just on 12%. Go to and they have a calculator you can use to see how long it will to pay off your debts by making the minimum payments, it will scare you to death.

Also, if the debtor has been paying the creditor for 5 years, then the creditor most likely has received everything they lent to you. But why do you owe almost the same amount that you originally borrowed, because a majority of your payment goes toward interest.

Now, when the bank receives a settlement of 40%, then that is icing on the cake at this point. They already collected everything you borrowed and now they are getting another 40%. I feel that 40% is more than enough.

Guest's picture

Another solution is seeking for IVA HELP. It is very useful especially for large debts that have large interest rates.

Guest's picture

There are many things that are just missing from this picture although it's a much better article about debt settlement then what else is out there.

let me tackle a couple of things first:

-in searching for a DS company, going to the BBB for references is a terrible idea as in some areas they assign an automatic "F" to anyone in the industry regardless of reputation and ethics

-secondly...please please don't borrow money to settle a debt. if a friend or a family member GIVES you the money, then fine, but don't ruin your relationships for debt, you have enough going on already.

OK so being an expert in the industry (I co-founded I can tell you a few things:

1. yes you can settle your own debt and you can save ON YOUR OWN towards a lump sum, so if you don't have it now don't worry about it.

2. dent settlement is not as easy as just calling the bank and saying "hey take this money because it's all I have." if it were that easy an entire industry would not have sprung up.

3. it is a process where if you are organized in your efforts and know what you are doing you can get "favorable" settlements from the creditors.

Lastly, one negative aspect this article forgot to mention is that you will have to deal with collection calls regardless of hiring a debt settlement company or doing it on your own. Any company that tells you they will stop the calls...stay away from.

The industry is in a midst some changes pending some new regulations that will limit the amount of fees they can charge and how they charge them. honestly I would not pay a company more than 10% of the total debt to settle my accounts (if I didn't know or want to settle them on my own)

Try this if you chose a debt settlement company...try and negotiate their fee haha, I'm sure they are so desperate for your business that you could bring them down to charging you only 10%, the more debt you have the less they should charge you as a percentage.

Anyways, I'm glad articles like this one are coming out that at least did some research before coming out as writers that don't know what they are talking about