Wiki page explains it pretty well. Settlement free is the key term. Pretend you and I are both ISPs. You are a large enough ISP that all other ISPs wish to peer with you for $0. However I am a smaller ISP and when I say, how about we have a settlement free peering agreement they laugh in my face and say "no you gotta pay". That makes you tier 1 but me tier 2 (or lower) even if I have settlement free transit through all of my other interconnects.