Debt Settlement
A debt relief strategy in which a borrower negotiates with creditors to pay a lump sum less than the full balance owed in exchange for the debt being forgiven.
What is Debt Settlement?
Debt settlement is a process in which a borrower — often severely delinquent — negotiates with a creditor to pay a reduced lump-sum amount in full satisfaction of the outstanding debt. Creditors may agree to settle for 40–60 cents on the dollar rather than risk receiving nothing in a bankruptcy. While debt settlement can reduce the total amount owed, it carries significant downsides: the forgiven amount is generally taxable as ordinary income (unless the borrower is insolvent), the late payments and settled status are reported to credit bureaus and damage credit scores, and accounts must typically be severely delinquent before creditors will negotiate. Debt settlement companies charge fees of 15–25% of enrolled debt but are prohibited from charging fees before settling a debt.
Example
A borrower has $30,000 in credit card debt across three cards and cannot make minimum payments. After six months of non-payment, a settlement company negotiates a lump sum of $15,000 ($12,000 to the creditor, $3,000 in fees). The creditor reports the account as 'settled for less than the full amount,' damaging the borrower's credit, and the $15,000 forgiven amount is issued as a Form 1099-C for tax purposes.
Source: Consumer Financial Protection Bureau — Debt Settlement