What Happens During Debt Settlement? Accounts, Collections and Charge-Offs

During debt settlement, you or a for-profit debt relief company negotiate with creditors to try to get them to accept a lower payoff amount. But the process doesn't stop an account from moving through the various stages of delinquency. While you attempt to reach an agreement, creditors can close, charge off or sell accounts to collections. 

Key Takeaways

What happens during debt settlement comes down to one thing: negotiating doesn't pause the clock on your accounts. Here's what to keep in mind.

• Settlement doesn't stop delinquency. While you negotiate, accounts can keep aging past due, so you might still need to pay late fees and penalty interest, and they may be closed or restricted.

• A charge-off can hit in 120 to 180 days. Creditors typically write off a debt as a loss after about 120 to 180 days of missed payments, but you still owe the balance until it's paid, settled or discharged.

• Negative marks can stay up to seven years. Missed payments, charge-offs and collection accounts can remain on your credit report for up to seven years from the date of first delinquency, even after you settle.

• Paying or settling doesn't erase the record. A settled account updates to "settled" or "paid for less" with a $0 balance, but it stays on your report — though newer scoring models like FICO 9, FICO 10 and VantageScore 4.0 weigh paid accounts more leniently.

• Collection efforts can continue — and ramp up. Creditors or collectors may still call, send letters, add fees or file a lawsuit while you negotiate, so watch for and respond to any legal notices. Under the FDCPA, collectors can't call before 8 a.m. or after 9 p.m.

• Confirm who owns the debt and get it in writing. Verify whether the original creditor or a collector holds the account before you negotiate, then keep a written agreement and check your free reports to confirm the update.

Summary generated by AI, verified by MoneyLion editors

MoneyLion offers a service to help you find personal loan offers. Based on the information you provide, you can get matched with offers for up to $100,000 from our top providers. You can compare rates, terms, and fees from different lenders and choose the best offer for you.

What Happens During Debt Settlement? 

Generally speaking, the debt settlement process begins when you or a debt relief company initiates negotiations with creditors. At this time:

1. You might stop making payments, so your accounts become increasingly past due.

2. The creditor could close or limit access to the account.

3. Late fees and interest, often at penalty rates, may accrue.

4. The creditor could “charge-off” the debt or write it off as a loss.

5. A collection agency might buy the debt from your original creditor.

6. This collector could attempt to recoup the debt.

7. Whoever "owns" the debt could file a lawsuit against you.

8. You could incur credit score damage from all associated negative activity.

How Your Account Status Can Change

The Account May Be Closed or Restricted

Asking for a settlement is effectively an admission that you can't repay a debt as agreed, and may prompt a creditor to close or restrict access to the account. 

In fact, credit card issuers often suspend borrowing privileges or otherwise limit functionality at earlier signs of risk, including missed payments and credit limit overages. This move blocks struggling borrowers from utilizing any available credit and curbs the creditors' losses.

Post-settlement, you should expect the account to remain closed.

A Charge-off Doesn't Erase the Debt

Charge-offs occur when a creditor writes your debt off as a loss, usually 120 to 180 days after your first late payment. That doesn't mean you no longer owe the debt. It's simply an accounting measure by the creditor, intended to ensure their books and balance sheets accurately reflect their financial health.

You're still responsible for paying off any outstanding charge-off balances until you fully repay, settle or get the account discharged through bankruptcy or other legal processes. The charge-off doesn't automatically discharge what you owe.

The Debt May Move to Collections or Be Sold

Once an account is charged off, in default or otherwise seriously delinquent, a creditor may hire a debt collector or sell the account to a collection agency. That way, they recoup at least some of their losses and no longer have to devote in-house resources to securing repayment. 

Due to this business tactic, it's important to confirm who “owns” your debt — the original creditor or a collector — before initiating settlement negotiations. 

Does Settled Debt Count as Taxable Income?

Settled or forgiven debt of $600 or more is generally considered and reported as income to the Internal Revenue Service (IRS). To do so, you’ll have to fill out form 1099-C titled “Cancellation of Debt.”

According to the IRS forgiven debt is treated as a financial benefit and is therefore considered taxable income. You essentially received goods, services or credit that you never had to pay back in full.

For example, if you settle an $8,000 debt with $5,000, the $3,000 difference will be treated as taxable income. You received goods or services that you technically didn’t have to pay in full for.

Not all forgiven debt is necessarily taxable. If you’re insolvent — the amount of debts exceeds your assets — you may not owe tax on the forgiven amount. There are some other exceptions noted by the IRS including amounts canceled as gifts or inheritances, certain student loan discharges and cancellation due to death or total permanent disability of a student.

If you’re unclear about this rule, it's best to consult a tax professional.

What Happens to Your Credit Report and Collection Activity? 

Negative Credit History May Still Be Reported

Creditors aren't blocked from reporting account information once you've initiated or they've even agreed to settlement negotiations. 

In fact, one of the biggest drawbacks of settling your debt is that the missed payments, charge-offs, new collection accounts — essentially any notes that indicate a settled account — can appear on your credit report and damage your credit score.

Plus, these line items won't disappear if and when you reach a settlement. They can remain on your credit file and affect your creditworthiness for up to seven years. Fortunately, the effects should lessen over time.  

What Does a Settled Account Look Like on Your Credit Report?

A settled account may appear on your credit report with a $0 or no balance — generally after it's been “settled,” “paid settled,” “settled for less than the full balance” or “paid for less than the full balance.”

This or similar verbiage indicates to credit scoring models and lenders that you didn’t pay in full, and may hurt your credit score, alongside any missed payments, charge-offs or collections that preceded the settlement. Remember, negative information may take up to seven years to fully “age” off of your credit report.

The good news? Their effects will decrease over time and your score should be spared from any new negative activity related to the account. Plus, newer credit scoring models ignore paid or settled collection accounts entirely.

Collections May Continue Until There's an Agreement

Debt settlement doesn’t preclude debt collection attempts. Creditors or agencies can still call, send letters, charge fees or file lawsuits while you negotiate — and some may ramp up their efforts once you ask for a settlement in order to recoup a larger portion of what they're owed.

That’s why it’s important to keep an eye out for and respond to any legal notices. You might also want to familiarize yourself with debt collection protections, so you can recognize when a creditor or collector is overstepping.  

Debt Settlement Effects: What Changes and What Doesn't

This chart recaps the major ways in which debt settlement can affect account status, debt levels, collection attempts and your credit profile.

What To Check Before and After Settling an Account

Confirm Who Owns the Debt

That way, you know which company — the creditor or a collector — you need to negotiate with to officially settle the account. You can do so by contacting the original creditor, requesting debt validation letters from collectors or checking who currently owns or collects the debt on your credit report. 

Get the Agreement in Writing

A formal agreement provides important legal cover if a dispute emerges over the settlement's terms. It helps to include:

• The agreed-upon amount

• How any remaining balances will be treated

• Your payment due dates

• The date by which the debt is considered paid in full

• Payment method

• Credit reporting or collection requests

Check the Account After Payment

In addition to a written agreement, it's important to ask for and keep a receipt of your final payment. You'll also want to check your credit reports to confirm that the creditor has correctly updated an account’s balance and status. Remember, they should appear as “settled” with either no balance or a $0 balance.   

You can request free weekly credit reports from Equifax, Experian and TransUnion at AnnualCreditReport.com. If you find an error, contact your creditor or consider filing a dispute with the credit bureaus.  

Should You Hire a Debt Settlement Company or Negotiate Yourself?

There are two different ways you can decide to deal with your debt — you can either hire a for-profit debt settlement company or negotiate with the creditors on your own.

Option 1: Debt Settlement Company

If you decide to go with a debt relief company, be aware of the risks. The Federal Trade Commission (FTC) prohibits companies from charging an upfront fee before settlement. Other markers of a scam include:

• A company guarantees that they will settle the debt

• A company offers “fast loan forgiveness

• A company tells you to stop paying creditors

• A company sends an unsolicited text for your personal or financial information

Option 2: DIY Debt Settlement

The Consumer Financial Protection Bureau (CFPB) offers guidance on how to settle debt. Here's how to approach DIY debt negotiation:

• Confirm the debt

• Determine what you can afford

• Negotiate the amount with the creditor

• Get the agreement in writing

• Stay current with the agreement

How Do You Decide? Debt Relief vs. DIY

If you decide to go with a debt relief company, be aware that this is the agent you’ve chosen to help you negotiate what you owe. There's a cost associated with help from a debt relief company. The typical cost ranges from 15% to 25% of the enrolled debt. Using an agency could save time and money, but ultimately, you're responsible and have to live with the outcome.

With a DIY method, you may have some questions as you navigate the process, but there's no extra cost associated with negotiating your debt. However, because of inexperience, you may risk some missteps.

If you pick a debt relief company, make sure you check the company's Better Business Bureau record, look at online reviews and confirm the company's fee structure. Also, any agreements with the creditor whether via DIY or a debt relief company get it in writing.

Does the Statute of Limitations Affect Debt Settlement?

According to the FTC, most debts have a statute of limitations depending on the state and the debt type. Once the statute of limitation expires, the creditor is barred from suing you for the debt.

If you’re tempted to make a payment on an old debt, you assume the risk, in some states, that can restart the statute of limitations clock. If you decide to repay a debt, be certain to check the debt’s age and the corresponding state statute before you decide to make a payment. This step is important because your good faith payment may resurrect an unenforceable or dead debt.

What Are the Alternatives to Debt Settlement?

You don’t necessarily need to stick with a debt settlement to resolve your debts. There are other alternatives including debt management plans, debt consolidation loans or bankruptcy.

• Debt management plans. A debt management plan doesn’t reduce your debt but consolidates your payments with the help of a nonprofit counselor.

• Debt consolidation loan. You bundle multiple unsecured debts into a new loan. You pay the lender a single payment.

• Bankruptcy. If you’re in severe financial distress and no other option will work for you, you can file Chapter 7 or Chapter 13 bankruptcy. A bankruptcy can appear on your credit report for up to 10 years.

Good To Know

A debt settlement makes sense when you want to avoid bankruptcy and also have a lump sum to settle what you owe. To start you may want to consider a nonprofit credit counselor since those services are free.

Final Take

Debt settlement doesn't pause payment obligations, even if a creditor is willing to negotiate. Your accounts can still move through delinquency, be charged off or sold to collections before you reach an agreement. To best benefit from debt settlement, aim to confirm your creditor, get key terms, like the final payoff amount and payment date, in writing and verify that the account's balance and status has been updated on your credit reports.   

FAQ

Can an account be settled before it's charged off?

Yes, a creditor may agree to settle a debt before it officially becomes a charge-off — and securing an agreement ahead of this step could prevent some damage to your credit score. A charge-off is treated as a major red flag by most credit scoring models.

Can a settled account still hurt your credit?

Yes, a settled account can still hurt your credit, as that status signals to credit scoring models and lenders that you paid less than you originally owed. Plus, any late payments, charge-offs, collection accounts and other negative information that preceded the settlement can stay on your credit report for up to seven years.

What happens if I miss a settlement payment?

If you miss a settlement payment, the creditor may be able to cancel the settlement agreement, add on back some of the debt and start trying to collect again. It’s a good idea to contact them directly once you realize you might miss a payment.

Do I have to pay taxes on money saved through debt settlement?

Yes, generally any forgiven debt of $600 will mean you need to pay taxes. You’ll typically need to file a 1099-C to report your taxable income unless you qualify for an exception. Contact a tax professional if you’re unsure of your tax liability.

Is it better to settle debt on my own or hire a debt settlement company?

DIY will help you save on fees, but if you need assistance or feel uncertain at any point during the process, a debt relief company may help. It depends on whether you want to exchange cost for convenience. Keep in mind legitimate companies can’t ask for payment before settling your debts.

Can a creditor still sue me for old debt during settlement negotiations?

Yes, if your debt is still within the statute of limitations for your state. Don’t make a payment on an old debt without checking the statute of limitations. It could restart the clock on the statute of limitations of your debt.

Key Terms

• Debt settlement: Negotiating with a creditor or collector to accept less than the full balance to resolve a debt. Approval isn't guaranteed, and the process doesn't pause delinquency.

• Charge-off: A creditor's accounting move to write a debt off as a loss, usually after about 120 to 180 days of missed payments. You still owe the balance.

• Collections: When a creditor sells or assigns an unpaid debt to a third-party agency that then pursues repayment, often after roughly 120 days.

• Date of first delinquency (DOFD): The date you first missed the payment that wasn't caught up. It starts the seven-year reporting clock and can't legally be reset.

• Debt validation: Your right to request written proof that a debt is yours and the amount is correct before paying. 1099-C: The "Cancellation of Debt" form a creditor files when it cancels $600 or more, with a note that forgiven debt is generally taxable but has exceptions — insolvency, bankruptcy, certain student loan discharges.

• Statute of limitations: The limited window a creditor/collector can sue, that it varies by state and debt type, and that a payment or written acknowledgment can restart the clock in some states.

Sources

• CFPB. How do I negotiate a settlement with a debt collector?

• CFPB. What is a debt relief program and how do I know if I should use one?

• CFPB. How long does information stay on my credit report?

• CFPB. What is an original creditor and what is the difference between an original creditor and a debt collector?

• CFPB. What information does a debt collector have to give me about the debt?

• FTC. How To Get Out of Debt.

• myFICO. Pros and Cons of Debt Settlement.

• myFICO. FICO Score Versions.

• VantageScore. Credit Scoring 101: Factors That Affect Your VantageScore Credit Score.

• IRS. Form 1099-C, Cancellation of Debt.

• IRS. About Form 1099-C, Cancellation of Debt.

• IRS. Topic no. 431, Canceled Debt — Is It Taxable or Not?

• FTC. Debt Relief and Credit Repair Scams.

• FTC. Looking for Debt Relief? Here's How to Avoid a Scam.

• FTC. Debt Collection FAQs.

• CFPB. How to Get a Handle on Debt.

• CFPB. What do I need to know about consolidating my credit card debt?

Rudri Bhatt Patel contributed to the reporting for this article.

Summary generated by AI, verified by MoneyLion editors

Photo credit: David-Prado/Getty Images/iStockphoto