Debt Settlement Pros and Cons: Costs, Credit and Taxes

On this page

• How debt settlement programs work
• What the FTC's rule requires of settlement companies
• No fee until a debt is settled
• Rules for the dedicated account
• Disclosures before you sign up
• The cons of debt settlement
• Your credit takes a hit
• Creditors don't have to settle, and they can sue
• What you owe keeps growing
• Forgiven debt can be taxed
• Fees eat into the savings
• The pros of debt settlement
• What debt settlement costs: an illustrative example
• How to check a debt settlement company
• Alternatives, from gentlest to most drastic
• Pay it off yourself
• Nonprofit credit counseling
• Debt settlement
• Bankruptcy
• Bottom line
• Common questions
• Sources

Written from primary sources by our editorial team. A credentialed reviewer hasn't signed off yet, so this page isn't in search results. It's information, not financial, tax or legal advice.

Debt settlement pros and cons come down to one trade. A settlement can close a large unsecured debt for less than the balance. Getting there usually costs you missed payments, credit damage and company fees, and it can bring lawsuits and a tax bill on the forgiven amount. It can make sense when repaying in full isn't realistic, but it belongs after the cheaper options in how to get out of credit card debt, not before them.

How debt settlement programs work

According to the FTC, for-profit companies typically offer debt settlement programs to people with significant credit card debt. The CFPB describes these companies as ones that often claim they can negotiate with your creditors to reduce the amount you owe.

A typical program runs like this:

1. You enroll unsecured debts, such as credit cards.
2. You stop paying those creditors. The CFPB says settlement companies typically encourage you to stop paying your credit card bills.
3. Every month you put a set amount into a dedicated account until there's enough to pay a settlement.
4. The company makes an offer. If a creditor accepts, money from your account pays that creditor, and the company can then take its fee.
5. This repeats debt by debt until everything enrolled is settled or you leave the program.

Most of the risk sits in step 2. In the months between your last payment and a settlement, fees and interest pile up, and collection calls or a lawsuit can come.

What the FTC's rule requires of settlement companies

The FTC's Telemarketing Sales Rule covers debt relief companies that sell by phone, and that includes calls you make in response to their ads. It gives you three main protections.

No fee until a debt is settled

The FTC says a company can collect a fee only after three things have happened. It has renegotiated, settled, reduced or otherwise changed the terms of at least one of your debts. There is an agreement between you and the creditor. And you've made at least one payment to the creditor under that agreement. The regulation itself is at 16 CFR 310.4.

The fee also has to track results. The company can charge a slice of its total fee in proportion to the debt that was settled, or a percentage of what it saved you. If it uses a percentage, that percentage has to be the same for each of your debts.

Rules for the dedicated account

A company can require you to save in a dedicated account only if all of these are true:

• The account is at an insured financial institution.
• You own the money, including any interest, and you can withdraw it at any time.
• The company running the account isn't owned or controlled by the settlement company or affiliated with it, and it doesn't pay or accept money for referrals.
• You can quit the program at any time without penalty. If you do, the money in the account comes back to you within seven business days, minus any fees the company already earned.

Disclosures before you sign up

Before you enroll, the company has to tell you how long results will take, what it charges, and how much you must save for each debt before it makes an offer. Under 16 CFR 310.3, it must also say the service will likely hurt your creditworthiness, may lead to collections or lawsuits, and may increase what you owe as fees and interest build. If it uses a dedicated account, it has to say the money is yours and you can leave at any time without penalty.

The cons of debt settlement

Your credit takes a hit

The FTC is blunt: your credit report and credit score are likely to be damaged. The CFPB says settlement can have a negative impact on your credit scores and on your ability to get credit in the future.

Creditors don't have to settle, and they can sue

The FTC says your creditors have no obligation to agree to negotiate a settlement of what you owe. The CFPB notes that many lenders do not negotiate with debt settlement companies. While you're saving, you may still get calls from debt collectors, and the FTC warns you could even be sued while you're waiting for a settlement.

What you owe keeps growing

When you stop paying, the CFPB says you will usually incur late fees, penalty interest and other charges. Those charges keep adding to the balance for as long as a debt waits its turn. The CFPB's warning is direct: debt settlement may well leave you deeper in debt than you were when you started.

Leaving partway through can be the worst of both. You could have paid fees on the debts that settled, still owe bigger balances on the ones that didn't, and carry the credit damage either way.

Forgiven debt can be taxed

The IRS says that if your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable in general. The creditor may send a Form 1099-C showing how much was canceled and when. According to IRS Publication 4681, canceled debt still has to be reported as income even if no 1099-C arrives, unless an exception or exclusion applies.

One exclusion is insolvency. The IRS counts you as insolvent to the extent your total liabilities were more than the fair market value of all your assets immediately before the cancellation, and canceled debt is left out of income up to that amount. Say your debts total $30,000 and your assets are worth $22,000 right before a debt is canceled. You're insolvent by $8,000, so up to $8,000 of forgiven debt could be excluded. The exclusion is claimed on Form 982, attached to the federal return, and it comes with a required reduction of certain tax attributes. A tax professional can check the numbers before a settlement closes.

Fees eat into the savings

The CFPB says debt settlement companies often charge expensive fees. Fees differ from company to company, so compare the fee each one discloses. The CFPB also says settlement companies usually can't get better terms than you could get by negotiating with your lenders and debt collectors yourself.

The pros of debt settlement

The case for settlement is narrow, but it's real:

• If a creditor agrees, you pay less than the full balance and that debt is resolved. For someone with large unsecured debt they can't repay in full, that can be a path forward.
• Under the FTC rule, a covered company isn't paid until a debt is actually settled and you've made a payment under the deal.
• Money in the dedicated account stays yours, and you can leave without a penalty.

All of that depends on creditors saying yes and on you keeping up the deposits.

What debt settlement costs: an illustrative example

The cost depends on what creditors accept, what the company charges, how long it takes and your taxes. We don't quote typical settlement percentages or fees because we haven't found a primary source that publishes them. The estimator's defaults below are adjustable assumptions, not quotes or market data, so swap in what a company actually discloses to you.

Here is what those defaults give for $20,000 of enrolled debt, with no insolvency exclusion.

Read the table as a best case. It assumes every debt settles at its starting balance, and it leaves out late fees and interest added while you're not paying, the cost of a lawsuit, and debts that never settle. A fee based on the amount saved, which the FTC rule allows, would change the math, and insolvency could shrink the tax line.

How to check a debt settlement company

• Check the company with your state attorney general and your local consumer protection agency, as the FTC recommends. A clean record doesn't prove a company is legitimate.
• Ask whether debt relief companies must be licensed to work in your state, and whether this one is. Your state attorney general or financial regulator can tell you.
• Search the company's name in the CFPB Consumer Complaint Database. The CFPB cautions that the database isn't a statistical sample, and a low number of complaints doesn't necessarily mean little or no harm.
• Get the required disclosures in writing and check them against the rule's list above.

Alternatives, from gentlest to most drastic

Pay it off yourself

If your balances go down at the budget you have, a payoff plan in avalanche or snowball order has no company fees and you don't have to stop paying anyone. You can also call creditors and ask for a lower payment or a settlement yourself. If you reach a deal, the CFPB says to get the plan and the collector's promises in writing before you make a payment.

Nonprofit credit counseling

The CFPB says credit counseling organizations are usually non-profit organizations. With a debt management plan, you make one payment to the counseling organization and it pays your creditors. The plan typically lowers your monthly payments along with interest charges and fees. Counselors may charge fees for some services. The FTC says a plan can take 48 months or more, and you might have to agree not to apply for or use more credit until it's done.

Debt settlement

Bankruptcy

The FTC says bankruptcy is generally considered a last option because of its long-term negative impact on your credit. A bankruptcy attorney can explain how the law applies to your debts. The pillar guide on how to get out of credit card debt explains how bankruptcy works and where it fits.

Bottom line

Debt settlement can resolve large unsecured debt for less than you owe when repaying in full isn't realistic. You pay for that with credit damage, fees and possibly taxes, and creditors can refuse or sue along the way. Run your own numbers with the settlement estimator, check any company with your state, and talk to a nonprofit counselor before you stop paying anyone.

Common questions

Does debt settlement hurt your credit?

Yes. The FTC says your credit report and credit score are likely to be damaged, and federal rules require settlement companies to tell you the program will likely hurt your creditworthiness before you sign up.

Is forgiven debt from a settlement taxable?

Generally, yes. The IRS treats canceled debt as taxable income unless an exception or exclusion applies. One exclusion covers people who were insolvent just before the debt was canceled, and it is claimed on Form 982. A tax professional can tell you how the rules apply to your situation.

Can a debt settlement company charge fees upfront?

Not under the FTC's Telemarketing Sales Rule. A company covered by the rule can't collect a fee until it has settled or changed at least one of your debts and you've made at least one payment under that agreement.

Can a creditor sue me while I'm in a settlement program?

Yes. Creditors don't have to agree to a settlement, and the FTC warns you could be sued while you're waiting for one. You may also keep getting calls from debt collectors.

Can I settle a debt myself without a company?

Yes. The CFPB says settlement companies usually can't get better terms than you could get by negotiating with your lenders and collectors yourself. Get any agreement in writing before you pay.

Sources

1. 1FTC: Debt Relief Services and the Telemarketing Sales Rule: A Guide for Business
2. 2Cornell LII: 16 CFR 310.4, Abusive telemarketing acts or practices
3. 3Cornell LII: 16 CFR 310.3, Deceptive telemarketing acts or practices
4. 4FTC: How To Get Out of Debt
5. 5FTC: Looking for debt relief? Here's how to avoid a scam
6. 6CFPB: What is a debt relief program and how do I know if I should use one?
7. 7CFPB: What is the difference between credit counseling and debt settlement, debt consolidation, or credit repair?
8. 8CFPB: What is credit counseling?
9. 9CFPB: How do I negotiate a settlement with a debt collector?
10. 10CFPB: Consumer Complaint Database
11. 11IRS: Topic no. 431, Canceled debt: Is it taxable or not?
12. 12IRS: Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments
13. 13IRS: About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness

By DebtCheckUSA Editorial Team. First published September 14, 2026. Advertiser disclosure