Debt settlement is a situation in which a creditor and debtor are able to reach an agreement to discharge an outstanding debt for less than the current amount of the debt. Creditors may choose to go this route when economic reversals render the debtor unable to pay the entire amount due. Sometimes referred to as debt negotiation or debt arbitration, the main function of the debt settlement is to prevent costly legal expenses and drawn out procedures while allowing the debtor to quickly decrease the number of obligations he or she is attempting to manage.

The use of debt settlement to eliminate outstanding debt is extremely helpful for the debtor. By making arrangements with creditors to pay a smaller fixed amount within a specified period of time, the need to declare bankruptcy is more or less eliminated. At the same time, the debtor can avoid the accumulation of more late fees and other charges that may apply to the credit accounts that are falling behind. In exchange, the debtor also agrees for the accounts to be closed to further purchase.

For the creditor, debt settlement makes it possible to avoid the possibility of the creditor filing for bankruptcy. In many cases, the creditor sees no more than a small percentage of the outstanding balance recovered once bankruptcy has taken place. It is not unusual for the creditor to receive no recovery whatsoever if the debtor has no assets that can be converted to cash and delivered to the court for distribution. The debt settlement provides the creditor with tangible proof of the creditor to honor as much of the debt as possible, and thus saves the creditor from incurring expenses associated with collection efforts or making use of other legal means in an attempt to collect the balance due.

There are some disadvantages to this type of debt reduction strategy. Often, a debt settlement will be listed as such on the debtor’s credit report. While not considered as unfavorable as a default, this type of listing usually does negatively impact the FICO score and the credit rating of the debtor. It may take years to recover and regain a good rating and a healthy FICO score.

Creditors also lose some of the revenue already showing as due, as well as lose all claim to any late fees or increased finance charges that would have applied if debtors continue to struggle to make minimum payments from month to month. Still, this partial loss of revenue is preferable to a complete default that cannot be collected, or having the debt wiped away by a bankruptcy action.

It is important to note that if the debtor does not honor the terms of the debt settlement, he or she is then open to legal action on the part of the creditor. Usually, a creditor will make no more than one debt settlement attempt with a debtor. If the debtor fails to honor the terms after agreeing to them, it is highly likely the creditor will use all legal means possible to collect the full amount due.