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Debt Settlement: Defined And Explained

Miranda Crace5-minute read
PUBLISHED: June 26, 2023


Financial health is extremely important, especially if you’re planning to save money for retirement, explore investment opportunities, become a homeowner or achieve other financial goals. However, debt can sometimes get in the way of your best-laid plans.

Debt settlement is an option available to those looking to reduce the amount of debt they owe in order to improve their financial health.

Let’s discuss everything you should know about debt settlement so you can decide if this debt relief strategy is right for you and your situation.

How Does Debt Settlement Work And What Is It Exactly?

Debt settlement takes place when a portion of your debt is wiped away and no longer your responsibility to pay. This loan settlement occurs after a negotiation between you and your creditors. The amount of money you no longer owe varies depending on the creditor and your specific financial situation. Keep in mind that if you have debt with more than one creditor, you’ll have to speak with each of them individually since it’s impossible to know which ones will allow debt settlement.

Don’t confuse debt settlement with a debt consolidation loan. The latter type of debt-reduction strategy is when all of your debt is combined into one loan. From there, you’ll make affordable monthly payments to pay down the amount of debt you have. The main difference between debt settlement and debt consolidation is that with debt consolidation, your debt won’t be forgiven like it can be with debt settlement.

Settlement Of Debt Example

For example, let’s say you have $15,000 in credit card debt. You discuss debt settlement with your creditor, and they decide to accept a $10,000 payment from you and forgive the other $5,000. That $5,000 is no longer your responsibility to pay and will be erased from your account.

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What Type Of Debt Is Eligible For Debt Settlement?

Now that you have an understanding of what debt settlement is and how it works, you might wonder about the types of debt that are eligible for debt settlement. The short answer: unsecured debt – that is, any debt that doesn’t involve giving up some form of collateral in exchange for access to funds. Examples of unsecured debt include:

  • Credit card debt: One of the most common debts forgiven with debt settlement is credit card debt. Since credit card debt is unsecured, it’s eligible for debt settlement.
  • Medical bills: Any unpaid medical bills are also considered unsecured and could be eligible for debt settlement.
  • Unsecured personal loans: Any debt you have through unsecured personal loans could be eligible for debt settlement.

What Type Of Debt Isn’t Eligible For Debt Settlement?

It’s also important to understand what type of debt that debt settlement can’t forgive. It’s a good rule of thumb to assume that if your debt is attached to a physical item (house, car, etc.) that could be taken, it’s not eligible for debt settlement. See examples below.

  • Mortgage loans: Since mortgage loans are tied to a physical home that a lender could take away, they’re not eligible for debt settlement.
  • Auto loans: Since auto loans are connected to a physical vehicle that a lender could seize, they’re not eligible for debt settlement.
  • Student loans: Student loans are usually not eligible for debt settlement unless they’re private loans and therefore not government sponsored.
  • Tax debt: If you have any tax debt from not paying the balance you owe, this type of debt isn’t eligible to be forgiven with debt settlement.

The Pros And Cons Of Debt Settlement

Like any type of financial strategy, debt settlement comes with clear advantages and disadvantages.


Here are some advantages of debt settlement to consider when deciding if this plan is right for you.

  • Your debt could be forgiven. The most significant advantage to debt settlement is the possibility of having some of your debt forgiven.
  • You can work with creditors on your own. You’ll have the ability to independently pitch a debt settlement offer to creditors, without any help from a settlement company.


Next are some disadvantages of debt settlement to keep in mind.

  • Settlement companies can be costly. If you choose a debt settlement company to help you work through a settlement plan with lenders and creditors, you’ll have to pay the company a fee that could be costly.
  • Your credit score could decrease. Since settlement companies will want you to stop making payments while they work through your plan, you could fall behind on payments, negatively impact your credit score and rack up late fees.
  • You might owe more money in taxes. The IRS counts settled debt as a form of income. Therefore, you might have to pay income taxes on the settled amount.
  • Creditors might not forgive your debt. There’s always a chance that lenders or creditors won’t agree to forgive any of your debt.

5 Alternatives To Debt Settlement

Debt settlement isn’t the only way to tackle mounting debt. Here are some other options to perhaps consider.

1. Debt Consolidation

As discussed, debt consolidation is when all of your debts are combined into one lump-sum loan (usually a personal loan) on which you’ll make monthly payments. The goal is to secure a lower interest rate on this loan so your monthly payments are more manageable and you can hopefully pay down your debt.

However, since debt isn’t being forgiven during the consolidation process, paying off your debt in full can take time. Making small payments will eventually get you to where you want to be financially, but patience is key here.

2. Bankruptcy

While this debt-reduction option can seem scary or overwhelming, it may be necessary to move past an extremely tough financial situation. Chapter 7 bankruptcy helps get rid of some of unsecured debts while Chapter 13 bankruptcy enables you to create a repayment plan to start paying secured debts while getting rid of unsecured debts.

3. Credit Card Balance Transfers

A balance transfer is when a credit card balance transfers over to a new credit card. This action will empty the old credit card and put your total unpaid balance onto the new one. A significant advantage of balance transfers is that your new credit card may have a 0% APR for a set number of months (usually the first year of opening the card). Zero interest on your monthly credit card payments could help you pay down some major debt.

4. Home Equity Loans Or HELOCs

If you’re a homeowner, you can take advantage of the equity you have in your home. Home equity loans allow you to use your house as collateral to borrow money. Doing this can enable you to consolidate your debts into one loan and make a monthly payment on it – potentially with a lower interest rate.

Similarly, with a HELOC (home equity line of credit), you still borrow against your equity. With a HELOC, however, you’re borrowing from a line of credit that you’ll start to pay back.

5. Debt Management Plans

Debt management plans are strategic plans put in place by the indebted borrower and a debt management company or nonprofit credit counseling agency. You’ll work together to develop a debt management plan that works best for your financial situation. From there, you’ll create a monthly payment plan where you pay the debt management company, and they’ll pay your creditors. Remember that this can take time, depending on the amount of debt you owe.

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The Bottom Line

Your debt doesn’t have to weigh you down forever, and it’s entirely possible to tackle it and get your finances in a better place. Debt settlement could be a smart option for those looking to eliminate a portion of their eligible debt, as long as they’re aware of the costs associated with this strategy.

However, debt consolidation, balance transfers, home equity loans, bankruptcy and debt management plans are also available to those looking for a different way to reduce or better manage their debt.

If you’re ready to focus on your financial health, prequalify for a personal loan to consolidate your debt.

Miranda Crace

Miranda Crace is a Senior Section Editor for the Rocket Companies, bringing a wealth of knowledge about mortgages, personal finance, real estate, and personal loans for over 10 years.