What Is Debt Relief, and How Does It Work?

Sometimes it seems like you’ll be stuck in debt forever, no matter how hard you try. But it is possible to get out of debt that leaves you feeling trapped. There are lots of ways you can do it, too. Debt relief programs are a common option for people who need a bit more help. 

The term “debt relief” can be confusing, though, since it’s not an official program. People actually use it to describe many different types of debt help, each of which work very differently. Here, we’ll cover the types of debt relief and take a closer look at one type of debt relief—debt settlement—so you can understand how it works and make an informed decision.

Table of Contents

1. What is debt relief?
2. How does debt settlement work?
3. Pros and cons of debt settlement
4. Is debt settlement right for me?
5. How to choose the right debt settlement company
6. FAQs

What is debt relief?

“Debt relief” is a general term for programs and outside assistance in reducing your debt burden. It’s different from DIY debt payoff methods like the debt avalanche and debt snowball methods, where you’re using your own strategies to pay off debt faster. Debt relief, on the other hand, is when someone helps you.

That debt help could come from a few different places. It could be a program that your lender offers, without anyone else acting as a middleman. Or, it could be a third-party company or organization that acts as a go-between, trying to negotiate with your lender to lower your debt burden. 

“Debt relief” is often synonymous with “debt settlement,” where a for-profit business tries to negotiate with your lender to settle your debt for a smaller amount than you currently owe. But it’s not the only type of debt relief.

Types of debt relief

Not all debt relief options work in the same way. 

• Bankruptcy: A legal process where a court determines which creditors, if any, will be repaid, with the rest of your debt being discharged. It can be costly and packs a big punch on your credit, but it can also be the fastest and most foolproof way to move on from your debt. There are different types of bankruptcy: Chapter 7 involves liquidating your non-exempt assets to pay off debts, while Chapter 13 sets up a three to five-year repayment plan that lets you keep your property.
• Debt settlement: A system where for-profit companies guide you into intentionally defaulting on your debt while also saving up a pot of money to use as a bargaining chip, in the hopes that your lender will accept a smaller one-time payment instead. 
• Credit counseling: A nonprofit agency that assigns a credit counselor to review your financial situation and offer support to help you make a decision. It’s free, with some low-cost options for additional support. 
• Debt management plans: A structured plan where a nonprofit credit counseling agency acts as a go-between to negotiate with your creditors for debt relief. It’s similar to debt settlement except you’ll still pay off the entire debt, but in a way that’s easier for you to handle.
• Lender debt relief programs: Lenders themselves are often very open to working with you to repay your debt, such as by offering temporary forbearance, long-term loan modifications, or even accepting debt settlement offers that you make yourself. 

I believe starting with a low-cost or free option is the best option for most people looking for debt relief. Having unbiased assistance can lead to better management of debt without destroying your credit score, or opening yourself up to other risks, such as being sued or spending money without any positive result.

Going straight to the lender for debt relief options is also a no-cost way to assess your options. We usually try to avoid suggesting debt settlement and bankruptcy unless they become unavoidable. These are extreme cases and most people do not fit the criteria needed for this recommendation.

How does debt settlement work?

Debt settlement is often thought of as synonymous with debt relief, even though, as we just covered, it’s not. Still, it’s worth diving into in more detail. It has the potential for high rewards, but also can have some pretty harsh consequences, too. Here’s a rundown of how debt settlement programs work:

1. You enroll specific debts into the program: Debt settlement companies can’t work with every type of debt. So, they’ll review your finances and let you know which ones they can handle. If you agree, you’ll sign a contract and enroll the debts in the program.
2. You stop making payments on those debts: Creditors don’t generally accept settlement offers unless they think you won’t pay them back. So, debt settlement companies advise you to stop paying your debts to intentionally default on them. 
3. You start saving each month toward a settlement offer: The debt settlement company will open a dedicated bank account for you. Each month, instead of paying your debts, you’ll deposit money into this new account to save up for a settlement. 
4. The debt settlement company tries to negotiate with your creditors: After a few months, the debt settlement company will reach out to your creditors and try to negotiate a settlement. 
5. You approve or deny any settlement offers: If they’re able to come to an agreement, the debt settlement company will notify you of the terms. You’ll give your stamp of approval before anything is finalized, however. 
6. The debt settlement company transfers the money: If you approve, the debt settlement company will make a withdrawal from your dedicated account. It’ll take its fee and transfer the rest to your creditor, who will forgive the remaining debt.
7. Repeat with remaining debt: If you enrolled more than one debt, the settlement company will keep repeating these steps until all of the debts your creditors are willing to negotiate on are settled. If the settlement company can’t settle a particular debt, it won’t charge you anything, and you’ll be left to handle it on your own. 
8. You receive a tax statement at the end of the year: Your old creditor will send you a Form 1099-C listing the amount of debt it forgave. You’ll need to include this as income on your tax return, which may cause you to owe additional taxes. 

Pros and cons of debt settlement

Pros

• Can help you avoid bankruptcy

  Aside from things like student loan forgiveness, debt settlement and bankruptcy are generally the only two legal ways you can pay back less than you owe.

• Potential to pay less than you owe

  When debt settlement companies were successful, they saved customers an average of about 32% for each individual debt settled in 2022, even after accounting for their fees. 

• Help from experienced debt negotiators

  You can negotiate with creditors yourself, but not everyone is comfortable doing so or has the extra time. That’s why many people prefer to hire someone to do it for them.

Cons

• Low success rate

  Only about half of debt settlement customers successfully complete the program. In contrast, 96% of people who file for Chapter 7 bankruptcy are successful. 

• Costs a lot of money

  Debt settlement companies typically charge 15% to 25% of your enrolled debt. The savings accounts you’re required to open also typically charge a monthly fee of $5 to $10. You’ll also have to pay penalties and accrued interest on any debts that the company can’t settle.

• Not legal in all states

  Debt settlement isn’t legal in about a third of U.S. states. Lawmakers banned these companies from operating out of concern that they’re harmful to consumers. 

• Triggers additional taxes

  Forgiven debt is treated as income, according to the IRS. If you’re in the 24% tax bracket and you have $10,000 of credit card debt forgiven, for example, you could owe an extra $2,400 on your taxes.

• Doesn’t help with all debts

  Debt relief companies only help with unsecured debts, such as credit cards or personal loans. They can’t help you with student loan debt, secured debt like your mortgage or car loan, or tax debt.

• Damages your credit score

  Defaulting on your debts can cause your credit score to drop precipitously, even lower than if you’d filed for bankruptcy in some cases. 

• High potential of being sued

  Up to 10% of debt settlement customers are sued by their creditors when they default on their debt, which can unlock a whole new whirlwind of costs and complications.

• Creditors can refuse to negotiate

  Most major credit card issuers have a set policy of not negotiating with debt settlement companies. Worse, it could trigger them into filing a lawsuit against you when they otherwise may have been open to negotiating a settlement offer with you directly, according to a 2021 government report.

A debt settlement strategy can decimate your credit score. It does so by negatively impacting your highest weighted score categories (credit utilization and payment history). It can take years to crawl out of this debt. When weighing this option, ask yourself if you need to use your credit for any major purchases or goals in the next five to seven years. If the answer is “yes,” consider other options because your credit score will likely not be high enough to qualify for favorable loans. If you do not need to use your credit for any type of loans in five to seen years, the negative impact to your credit score is more negligible, which means exploring this option becomes more likely.

Is debt settlement right for me?

Debt settlement isn’t right for everyone—but if any of the following ring true, it may be a path worth exploring:

• You already have a very low credit score.
• You’re already behind on your monthly payments.
• You’re too overwhelmed to negotiate directly with creditors.
• You’ve explored all of your other options and ruled them out. 
• You have regular income you can set aside to save up for a settlement offer.
• You’ll soon be in a better financial, emotional, and physical position to handle potential fallout effects, like high tax bills, lawsuits, and leftover debt that couldn’t be settled.

How to choose the right debt settlement company

If you’ve considered the pros and cons of debt settlement and still decide that it’s right for you, here are a few things to keep in mind as you research the best debt relief companies:

• Look for companies that are open and upfront about their fees. 
• Check if the company works with partner attorneys in case you’re sued, such as Freedom Debt Relief.
• Read as many reviews as you can find and pay attention to ratings. Accredited Debt Relief, for example, has a 5-star rating with the Better Business Bureau.

FAQs

How much does debt relief cost?

Debt relief costs vary depending on the type of program and your total debt amount. If you’re working with a debt settlement company, you’ll typically pay 15% to 25% of the total debt enrolled, but fees are only charged after a settlement is reached. For example, if you enroll $20,000 in debt and settle it for $12,000, your fee might be around $3,000–$5,000, making your total repayment closer to $15,000–$17,000.

Debt management plans (DMPs), offered by nonprofit credit counseling agencies, usually involve set-up fees of $25–$75 and monthly fees of $25–$75. These fees are regulated by state laws and may be waived based on financial hardship.

What happens if a debt relief company can’t negotiate my debt down further?

If a debt relief company is unable to reduce your debt significantly, a few outcomes are possible:

• You may still owe the full balance and must resume or continue making payments.
• The company may close the account and refund unused funds, minus any administrative or setup fees.
• You might be referred to alternative options, such as bankruptcy or debt management.

Be sure to read the service agreement closely—some companies may have a satisfaction guarantee or a refund policy if they don’t achieve certain results.

How is a debt settlement plan different from a debt management plan?

A debt settlement plan involves negotiating with creditors to pay less than what you owe—often in a lump sum or structured payments after a period of non-payment. It can significantly reduce your total debt but can also hurt your credit and may trigger tax liability on forgiven amounts.

A debt management plan (DMP), by contrast, is a structured repayment plan where you repay your full debt amount over 3 to 5 years with potentially lower interest rates or waived fees. DMPs are generally coordinated through nonprofit credit counseling agencies, and you continue making monthly payments, which may have a more neutral or even positive impact on your credit over time.