How Does Debt Settlement Work?

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When you choose debt settlement, you or a debt settlement company will contact your creditors and offer to pay a lump sum that is less than the total debt you owe. If the creditor agrees, the remaining balance is forgiven and marked as “settled” on your credit report.

 

Example:

You owe $10,000 on a credit card. You negotiate to pay $5,000 as a lump sum. The creditor accepts the offer, and the remaining $5,000 is written off.

 

Key Characteristics of Debt Settlement

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• Negotiation-based – Either you or a third-party negotiates a lower payoff.

• Lump-sum payment – You must typically offer a single large payment.

• Unsecured debt only – It’s generally used for credit cards, personal loans, and lines of credit.

• Voluntary agreement – Creditors are not required to accept a settlement.

 

Types of Debt That Can Be Settled

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Debt settlement typically works best with unsecured debts, including:

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• Credit card balances

• Personal loans

• Lines of credit

• Medical bills (in some cases)

• Collection accounts

 

Debt settlement does not apply to:

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• Secured loans (e.g., mortgages or car loans)

• Student loans (in most cases)

• Court fines or legal judgments

• Child support or alimony

• Government debts like taxes or EI overpayments

 

Do You Need a Debt Settlement Company?

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You can negotiate directly with your creditors, or you can hire a debt settlement company to do it for you. However, it’s important to choose a reputable firm, as the industry is known for scams and misleading promises.

In Canada, debt settlement companies must follow strict regulations, and many consumers choose to work instead with a Licensed Insolvency Trustee for more formal debt relief like a consumer proposal.

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Steps in the Debt Settlement Process

 

Step 1: Assess Your Financial Situation

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Before attempting settlement, determine:

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• How much you owe

• Who you owe it to

• How much money you can realistically offer as a lump-sum payment

 

Step 2: Stop Making Payments (Optional and Risky)

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Some people choose to stop making payments to creditors to encourage them to settle. This can:

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• Increase your debt due to interest and fees

• Damage your credit score

• Lead to collections or lawsuits

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This step should be considered very carefully and ideally discussed with a financial advisor or trustee.

 

Step 3: Make a Settlement Offer

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You (or a company on your behalf) propose an amount that you can pay immediately. It’s usually 40–60% of the total debt.

 

Step 4: Get the Agreement in Writing

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If the creditor accepts the offer:

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• Make sure you get the terms in writing

• Confirm the agreement states that the debt will be settled in full

• Ensure there will be no future collection actions

 

Step 5: Make the Payment

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Once the payment is made:

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• The debt should be considered “settled”

• You should receive written confirmation

• The creditor will report the status to the credit bureaus

 

How Does Debt Settlement Affect Your Credit?

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Debt settlement will appear on your credit report as “settled for less than full amount.” This is less damaging than bankruptcy but still hurts your credit score because it shows you did not pay the full amount.

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• The account may remain on your credit report for 6 years

• Your credit score will drop, but it may be possible to rebuild your credit over time

 

Pros of Debt Settlement

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• Can eliminate debt for less than you owe

• May help you avoid bankruptcy

• One-time payment provides closure

• Could reduce stress from collections and legal threats

• Typically faster than other repayment plans

 

Cons of Debt Settlement

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• Negative impact on your credit score

• Creditors aren’t obligated to accept your offer

• Must have access to a large lump sum of money

• May be taxed on the forgiven amount as income (depending on the province and situation)

• Debt settlement companies may charge high fees or make misleading claims

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Is Debt Settlement Right for You?

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Debt settlement may be a good option if:

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• You have a large amount of unsecured debt

• You’re behind on payments

• You have access to a lump sum of cash

• You want to resolve debt quickly

• Other solutions like a consumer proposal or consolidation loan aren’t feasible

 

Avoiding Debt Settlement Scams

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Not all debt settlement companies are trustworthy. Be cautious of:

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• Companies that demand upfront fees before settling anything

• Promises to eliminate all your debt

• Claims that they can stop all legal action

• Advice to ignore creditor calls or court summons

 

In Canada, Licensed Insolvency Trustees (LITs) are federally regulated professionals who offer more secure debt relief options like consumer proposals.

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Final Thoughts

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Debt settlement can be a useful tool, but it comes with risks and is not for everyone. It can save you money and help you avoid bankruptcy—but you need to go into the process fully informed.

 

At Capital Corner, we’re here to help you understand all your options. If you're feeling overwhelmed by debt, exploring settlement is just one step toward financial freedom. Before choosing any debt solution, always speak with a qualified professional to make sure it fits your unique situation.