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How Does Debt Relief Actually Work?
By Staff MONEY RESEARCH COLLECTIVE
With the high cost of housing, groceries and other basics, people are increasingly relying on debt to cover their expenses. According to Experian, one of the major credit bureaus, consumers had an average of $104,215 of debt in 2023.
If your debt has gotten out of control and you feel like you’ll never be able to repay it, debt relief, also called debt settlement or debt negotiation, can be appealing. Through debt relief programs, you may be able to repay only a portion of the total you owe and ultimately eliminate your debt.
When Does Debt Relief Make Sense?
Debt relief is a process where you negotiate with your creditors to pay off, or “settle,” your accounts by paying less than you owe — often as a lump sum. For example, if you owe $10,000, you might offer to pay a lump sum of $6,000, and the creditor agrees to the reduced amount and closes the account. They forgive the remainder and consider the debt settled.
You can handle debt settlement on your own, but it can be a complex process, and working with a professional debt relief company can be a good idea.
Debt settlement companies work on your behalf to negotiate with your creditors and come to an agreement to reduce what you owe. This approach can make sense in the following scenarios:
- You’re experiencing a financial hardship like job loss, divorce or a medical emergency
- You are struggling to keep up — or have fallen behind — with your minimum monthly payments
- You’re contemplating declaring bankruptcy
- Your debt is severe enough you cannot pay it off within a few years
- The amount you owe is ballooning due to high interest charges on the revolving debt
- You have the ability to make a lump sum payment, or are willing to save up to do so.
The American Association for Debt Resolution (AADR) said that people who participate in debt settlement programs typically slash their debt by about 50%. The median savings per household was $19,620 per household in 2023.
How Debt Relief Works
Debt settlement, whether you opt for a do-it-yourself approach or involve a professional debt relief company, involves the following steps:
1. Decide between a do-it-yourself approach or working with a company
You can settle your debt on your own; you have the option of contacting your creditors and offering a lump sum payment as a settlement. However, debt settlement requires extensive negotiation, and for those who are uncomfortable with high-pressure discussions or who don’t have the time to handle it themselves, using a debt relief company could be a good alternative.
Debt settlement companies are skilled in negotiating with creditors, and they often have established relationships with major financial institutions, making it easier for them to reach a resolution.
2. Research your options
Although debt settlement is possible nationwide, some states have stricter laws governing the industry than others. If you live in one of the following states, it may be more difficult to find a reputable debt settlement company: Connecticut, Georgia, Hawaii, Illinois, Iowa, Kansas, Maine, New Hampshire, New Jersey, North Dakota, Ohio, Oregon, Rhode Island, South Carolina, Vermont, Washington, West Virginia, and Wyoming.
To find the best debt relief programs in your state, visit the AADR member database.
When comparing your options, pay attention to the cost. Fees vary by debt relief company, but they usually range between 15% and 25% of the debt you include (or “enroll”) in a debt relief program. According to the AADR, the average fee is 16.8% of the enrolled debt. If you enrolled $10,000 in a debt relief program, that means you would pay about $1,680 in fees. Note that you do not pay these fees until after a company has successfully negotiated on your behalf (more on that below).
3. Find out if you meet the criteria for debt relief
To qualify for a debt settlement program, you usually have to meet certain eligibility requirements. Specifics vary by company, but you usually need to meet the following criteria:
- You have at least $7,500 in unsecured debt
- You have eligible debt (unsecured debt, such as credit cards and personal loans, qualify for debt settlement. Secured debt and federal student loans do not).
- You have a reliable source of income.
- You can demonstrate a significant financial hardship that is making it difficult to impossible to make your minimum payments.
4. Meet with the provider
Next, you’ll meet with the provider or speak with a representative over the phone. The representative will review your debt, discuss the debt relief company’s fees and structure, and explain the process to you.
The company will request financial documentation, such as recent creditor and bank statements, and will give you disclosures and agreements to review and sign.
Typically, debt settlement involves pausing any creditor payments, as companies aren’t likely to negotiate unless your accounts are in default.
5. Make consistent payments into the designated account
Once the process is complete, the provider will work with you to open a new dedicated savings account — this is a bank account set up for the purposes of building up funds for negotiations. Based on your income, expenses and timeline, the debt relief company will calculate a monthly deposit amount. While the debt relief company will help you determine the size of your deposits, you’re ultimately in charge of making them and retain control of the account.
Once you’ve accumulated enough to cover about 20% of your enrolled debt, the debt relief agency will contact your creditors to begin negotiating settlements.
6. Approve your settlement agreements
The debt relief provider will contact your creditors and negotiate a settlement with each one separately. If a creditor agrees to the proposed terms, the debt relief company will contact you with the settlement terms. You’ll have to approve the settlement agreement; many debt relief companies allow you to do this via text, with a mobile app or through an online dashboard. The money you accumulated in the dedicated account will be used to pay your creditors and settle the accounts. Note that this is the stage where you pay the fees to the provider; by law, debt relief companies cannot charge you for their services until they’ve successfully negotiated a settlement for you, you have approved the terms and the creditor has been paid.
Issues to Consider
Debt settlement can be a useful tool to help some people work toward a debt-free future, but there are some serious repercussions to consider:
- Taxes: When you settle your debt for less than you owe, the discharged amount is taxable as income, so you could owe a substantial amount on the settled debt.
- Credit Impact: When you pursue debt settlement, you stop making payments to your creditors to build leverage to negotiate. Those missed payments will be reported to the credit bureaus, hurting your credit score. Accounts that were delinquent typically appear on your credit report for seven years.
- Cost: The cost of debt settlement can be as much as 25% of your enrolled debt, which will offset the savings you gain from reducing the amount you owe.
- Results: Debt settlement results aren’t guaranteed. Some creditors refuse to negotiate with debt relief companies, so you may accrue interest and late charges without successfully settling your debt. While the companies cannot guarantee they’ll be successful in getting a creditor to settle, you can ask if they’ll offer some kind of guarantee that protects you if you end up owing more than you originally enrolled.
Before debt settlement, explore other options for managing your debt. By learning about other ways to get out of debt faster, you may be able to take back control of your finances without needing to turn to debt settlement.