Should You Consider Debt Settlement?

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Debt settlement companies are all over the radio, TV, internet, magazines… just about everywhere. With claims like “Be debt free in 12 months!” or “Pay off your debt for 10 cents on the dollar!”, they may sound too good to be true. In fact, they probably are.

What is debt settlement?

The easiest way to explain debt settlement (what it is, how it works, and if it’s a good idea) is with an excerpt from my newest book Life or Debt 2010.

Imagine that I owe you some serious money, say 10 grand. I faithfully made payments to you when I first borrowed the money five years ago, but since then I’ve lost my job and moved away. Now the payments have stopped. You’ve called me over and over, but despite your harassment, you haven’t gotten a payment from me in over a year.

Then out of the blue one day I call you up and say, “Gee, I’m really sorry about being such a jerk. But I’m still having trouble making ends meet. Here’s what I propose: I’ll borrow four grand from some other nitwit and send it to you today. If I do that, will you call it even? If you won’t accept that, I’ll be forced to file bankruptcy and never pay you back at all.”

You think it over and realize that $4,000 is better than nothing. So you take the money, remove me from your Christmas card list and head on down the road.

That is debt settlement: Offering to pay a smaller lump sum in exchange for erasing your debt. You can call up your creditor yourself and make them an offer. You can hire a lawyer to handle the offer for you (a bankruptcy lawyer would be a good choice). Or you can hire a debt settlement company.

Here’s a story I did on debt settlement in August ’09. Check it out, then we’ll go into a little more detail.

Dealing with Debt: Debt Settlement

Now, if you actually have the $4,000 on hand to send to a creditor to settle a $10,000 debt, great! Call them up and make an offer (or have a lawyer do it for you). But if you don’t have the cash, where do you get it? Most debt settlement companies will tell you to make monthly payments to them each month and, once you’ve got enough of it stored away, they’ll make a settlement offer to your creditor on your behalf.

In other words, if you’re currently making monthly payments on a credit card debt, a debt settlement company will probably want you to stop making those payment, and send the money to them instead. Good idea? Maybe.

You’re clearly going to screw up your credit history if you simply stop paying your debts. But, if you can’t keep up with them anyway (and have no hope of doing so in the future), the lump sum that you eventually settle for will probably be less than you would have paid if you had kept paying on time. This is especially true if your credit card company has jacked up your rates to 30% or 40% and/or hit you with a ton of penalties.

Debt settlement will kill your credit score

Essentially, you’re kind of screwing over your creditors by failing to make payments for a while, then settling for a substantially lower amount than you actually owe. This pisses them off (you’d be pissed if I did that to you), so expect that major hit on your credit score to be anywhere between 45 and 125 points (according to Fair Isaac).

Debt settlement can create a tax liability

Lets say you did pay off that $10,000 debt for only $4,000. Great job! But the $6,000 that you didn’t have to pay is called forgiven debt… and to the IRS, forgiven debts are taxable income. In other words, you now owe the government for an additional $6,000 of income. Consider that adding anywhere between $1,000 to $2,000 on your tax bill, and the actual amount you settled your debt for is really more like $5,000 or $6,000 depending on your tax bracket. (Note: some might qualify to skip the taxes: check out this post about the tax liability from forgiven debt.)

Debt settlement companies charge fees

Debt settlement companies typically charge about 15% in fees. You might think that’s 15% of the amount you settle for, but it’s usually 15% of the amount you originally owed. So if you owe $10,000 and settle for $4,000, in addition to the taxes you’ll pay on that forgiven debt, you’ll owe the debt settlement company another $1,500. That $4,000 settlement has now grown to as much as $7,500.

To me, paying $1,500 to have someone make a phone call to your creditor and offer less than what you owe seems pretty silly. Do it yourself and save the expense.

Debt settlement companies are largely unregulated

Unlike the credit counseling industry, the debt settlement industry is pretty much unregulated; you’ll find more than a few bad apples. Some agencies take huge fees up front before they even begin to settle your debt. Others have been charged with flat out stealing people’s money. And even the ethical ones tend to charge too much money for something you can do yourself.

Of course, i’m not going to say you should never ever deal with a debt settlement company. After all, it’s entirely possible that there are some really great ones out there somewhere. But here’s a little story…

Debt settlement companies are reluctant to talk on camera

While putting together the news story above (Dealing with Debt: Debt Settlement), it was almost impossible to find a debt settlement company willing to go on camera. Even one of their national associations refused to comment at all for the story. In my 20 years of TV news, I’ve never had that happen in any industry.

In order to finally get someone to interview, I ended up calling more than a dozen companies in a process that took weeks. Even a guy I’ve known personally for years, who works at one of these companies and has assured me many times that his company is totally reputable, wasn’t willing to go on camera to say so.

If that doesn’t mean much, consider this… if you owned a business and had the opportunity to talk about how great you were in front of 10 million viewers, absolutely free, wouldn’t you do it?

The bottom line

Right now, the entire debt settlement industry is under investigation by the New York Attorney General’s Office. So while it’s possible that there are good agencies out there, and debt settlement may work for a select few, I’d be very careful with any industry operating without regulation, that is afraid of talking to the media, and has been under investigation for bad behavior.

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Comments & discussion

We welcome your opinions, but let’s keep it civil. Like many businesses, we reserve the right to refuse service to anyone. In our case, that means those who communicate by name-calling, racism, using words designed to hurt others or generally acting like an uninformed bully. Also, comments that include links to email addresses or commercial websites typically aren't posted. This isn't a place to advertise your business.

  • http://www.facebook.com/khowler Karri Ward

    I wish that my parents had known about this years ago when we did this with MBNA. We were quite surprised at tax time that we now owed money on the amount they forgave.

  • Frank Gugliotta

    Dear Stacy,

    I took your advice and paid down some debt myself. As noted my credit scores took a huge hit downward. I now have returned to work and would like to purchase a home but my credit scores won’t allow me get a mortgage.
    What can i do to increase my scores and get a mortgage?

    Frank

  • http://DamonDay.com/blog Damon Day

    Hello Stacy,

    Great article. I am not surprised that you had a very difficult time finding a settlement company willing to be interviewed. When you shine the light on what most of these programs do they all scatter.

    It sounds really good in a sales pitch when they are dealing one on one with an uninformed consumer, but a simple glance at their business models, make it clear that most of these programs are in it for themselves, not the consumer.

    With the FTC considering regulations on banning these large upfront fees, many of these operators will go out of business, which is good for future consumers looking for help, but it will be devastating to the hundreds of thousands of consumers that are unfortunately already enrolled into these programs. When these companies are forced to close and move on to the next industry to plunder, all of their clients will be left out in the cold in worse financial shape than they were before they enrolled.

    The lesson is to absolutely never, ever, ever, enroll into a settlement program that charges most or all of their fees before completing most or all of the work. You wouldn’t pay a contractor to remodel your kitchen in full right after the demo stage, so why would you pay a settlement company this way.

    It defies all logic, but when people are scared and desperate for help, and the salesman is telling them all of the right things, consumers are willing to believe almost anything.

  • Angie Rincon

    You made “debt settlement” sound like the right path to take this morning on advising consumers , but now after reading “should you consider debt settlement” we don’t really have much of a choice! We are at their mercy

  • Republican

    Get a real job!! You are the king of finger pointers. It is the consumers fault like myself, that got me into this situation. And now that I have no other options out there this was was my best option. Alot of companies are reputable. just like any industry there are a few bad apples. Lawyers, Doctors, and sleezy Reporters that unfortunatley dont report all the facts!! I enrolled into Debt settlement 2 years ago and they settled all my Debt, and now I have a clean slate. Now, I can focus on rebuilding my credit and my life. BK was not an option for me nor was Credit Counseling, because all credit counseling is interest rate negoitators!!

  • Eternal Optimist

    I'm sure that debt settlement is not for everyone. But, my wife and I enrolled into a program with a debt settlement company 3 yrs ago and we had $50k in credit card debt. In Dec, we will be debt free. That's less than 4 yrs. Tell me where we went wrong????? Now, we can build our wealth!!!!!!

  • George

    This is great example of using misleading sensationalism. DEBT SETTLEMENT WILL KILL YOUR CREDIT SCORE is the huge title, but the actual 45 – 125 points (which it not that much of a killing) is neatly tucked within the paragraph's subtleties.