Debt settlement

What It Means

Debt settlement means getting a creditor to accept a single payment that's less than what you owe and to treat the rest as resolved. You can negotiate it yourself, and for-profit debt settlement companies also sell it as a program, usually for credit card debt. The Federal Trade Commission (FTC) notes these programs often tell clients to stop paying their creditors while money builds up for offers, which can hurt credit and lead to charge-offsCharge-offWhen a lender writes an unpaid account off as a loss and closes it; you still owe the money, and the mark can stay on your credit report for up to seven years. See more. Any forgiven part can count as taxable income.

How People Say It

• "They said they could cut our card debt in half."
• "We stopped paying the cards and put the money in the settlement account."
• "The bank took forty cents on the dollar."

The Breakdown

A short example. Andre and Mia owe $1010,000 stepsA popular daily step goal that began as the name of a 1960s Japanese pedometer; later studies find health benefits begin well below it. See more,000 on a credit card. An ad promises to settle it for about half, so they enroll with a settlement company, stop paying the card and send money into a savings account each month instead.

Where it goes wrong. While they save, the card's interestInterest rateThe yearly percentage a lender charges for borrowing money, not counting fees; the APR adds certain fees to show a fuller cost. See more and late fees keep landing, and by the time the creditor accepts an offer the balance has grown to $11,500. Settling at 50% costs $5,750. Their company's fee, 20% of the debt they enrolled in this example, adds $2,000. If the $5,750 the bank forgave is taxed as income at 12%, that's $690 more. Their total is $8,440, about $1,560 below the original balance, and the account now reports as settled for less than the full balance, a mark that stays seven years from the first missed paymentLate paymentA payment that reaches the lender after its due date; on credit reports, one that's 30 days or more past due. See more.

What to watch for

• An upfront fee. Under the FTC's Telemarketing Sales Rule, a company selling debt relief by phone can't collect a fee until it has settled or changed at least one of your debts and you have an agreement with the creditor.
• Instructions to stop paying. The FTC warns this can hurt your credit, and a creditor may charge off a debt after 4 to 6 months of missed payments while you still owe it.
• A Form 1099-C the next winter for any canceled debt of $600 or more.

Good to Know

The FTC's advance-fee rule took effect on October 27, 2010. It lets a company have you set money aside in a dedicated account only if the account is at an insured institution, you own and control the money, and you can leave at any time without penalty. Creditors don't have to accept an offer. On taxes, the IRS says canceled debt is usually income, with exceptions: the insolvency exclusion (when what you owed was more than everything you owned just before the cancellation) and debt canceled in bankruptcyBankruptcyA federal court process for people and businesses that can't pay their debts, ending in a discharge of many debts after an asset sale or a repayment plan. See more, both claimed on Form 982. Compare settlement with a debt management planDebt management planA repayment plan set up by a credit counseling organization: you make one monthly payment to it, and it pays your creditors, often at lower rates. See more through a nonprofit credit counselingCredit counselingAdvice from a trained counselor, usually at a nonprofit agency, on your budget and debts, which can lead to a debt management plan or other next steps. See more agency, and with bankruptcy, before you sign anything.

Related Terms and Categories

• Debt management plan

  A repayment plan set up by a credit counseling organization: you make one monthly payment to it, and it pays your creditors, often at lower rates.

• Credit counseling

  Advice from a trained counselor, usually at a nonprofit agency, on your budget and debts, which can lead to a debt management plan or other next steps.

• Bankruptcy

  A federal court process for people and businesses that can't pay their debts, ending in a discharge of many debts after an asset sale or a repayment plan.

• Charge-off

  When a lender writes an unpaid account off as a loss and closes it; you still owe the money, and the mark can stay on your credit report for up to seven years.

• Debt collector

  A person or company that collects debts owed to someone else, such as a collection agency, debt buyer or collection lawyer, limited by the FDCPA.

Debt and credit