Debt Settlement, Consolidation or a Debt Management Plan?

Three options side by side

The key question is whether you can afford to repay the full balance if the rate or fees come down. If you can, a DMP or consolidation usually costs less in the long run. Settlement is a tool for debts you truly can't repay, and it comes with real damage.

How debt settlement works and what it costs

A settlement company asks you to stop paying your unsecured creditors and instead deposit money each month into a dedicated account. Once enough builds up, it offers a creditor a lump sum for less than the balance. The FTC notes that creditors have no obligation to negotiate, and the process can take years.

Meanwhile, the accounts you stopped paying go delinquent. Late fees and interest keep adding up, collectors call, and a creditor can sue you before any deal is reached. The CFPB warns that settlement companies can't promise how much you'll save, and some debts may never settle.

Any company that asks for money before it settles a debt is a warning sign. So is one that promises to settle all your debts or tells you to stop talking to your creditors without explaining the consequences. More on spotting fakes in loan and debt relief scams.

Taxes on forgiven debt

If a creditor forgives part of what you owe, the IRS generally treats the canceled amount as taxable income. Settle a $9,000 card balance for $5,000 and the $4,000 difference may count as income for that year. The creditor may send you Form 1099-C, Cancellation of Debt, showing the amount and date; you are responsible for reporting the correct amount even if the form is wrong or never arrives.

The main relief is the insolvency exclusion. You were insolvent if, immediately before the cancellation, your total debts were more than the fair market value of everything you owned. You can exclude canceled debt up to the amount by which you were insolvent, by filing Form 982 with your return. Debts canceled in bankruptcy are also excluded. A tax preparer can tell you how this applies to you before you agree to a settlement.

Credit counseling and a debt management plan

A nonprofit credit counselor reviews your budget and, if it fits, sets up a DMP. You make one monthly deposit to the counseling agency, and it pays your unsecured creditors. Creditors may agree to lower your interest rates or waive certain fees, and to stop collection efforts and late fees while you're on the plan. The FTC says a plan can take 48 months or more, and you may have to agree not to open or use new credit until it's done. DMPs don't cover secured debts like a mortgage or car loan.

• Find a counselor through the National Foundation for Credit Counseling, the Financial Counseling Association of America, or the Justice Department's list of approved agencies.
• Ask about fees in writing. Nonprofit status doesn't make a service free or legitimate.
• Confirm with each creditor that it has accepted the plan before you stop paying it directly.
• Walk away from any agency that pushes a DMP as your only option without reviewing your budget.

Consolidating on your own

With fair to good credit you may be able to consolidate without anyone in the middle. A debt consolidation loan pays off your cards and leaves you with one fixed payment and an end date. A balance transfer card can pause interest for a promotional period, usually for a transfer fee; Funditia explains how balance transfers work.

Consolidation only saves money if the new APR, fee included, is clearly lower than what you pay now, and if the cards stay paid off afterward. The debt consolidation calculator compares both. If no new loan would beat your current rates, a payoff strategy or a DMP is the safer route.

What each option does to your credit

Settlement does the most harm, because it usually depends on months of missed payments. Those late payments, and an account reported as settled for less than the full balance, generally stay on your credit reports for seven years. A DMP may require closing or freezing the cards it covers, which can affect your score, but on-time payments through the plan build a positive record. A consolidation loan adds a hard inquiry and a new account, and paying down card balances often helps.

If debts are already in collection, know your rights before you negotiate: see debt collectors and your rights.

Common questions