Should You Consider Debt Settlement?

Photo (cc) by kainr

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 one of my books, 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 years ago in August of 2009. Check it out, then we’ll go into a little more detail.

Dealing with Debt: Debt Settlement

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

While there are laws that should theoretically protect you from bad apples in this business, that hasn’t stopped some from ignoring them. Some agencies take huge fees up front before they even begin to settle your debt: that’s not legal. 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

Over the years I’ve come to the conclusion that, while it’s possible that there are good agencies out there, and debt settlement may work for a select few, I’m not going to recommend any industry operating without regulation, that is afraid of talking to the media, and has been under investigation multiple times for bad behavior.

But don’t just take my word for it. Before you consider debt settlement, read more about it. A good place to start is with this article from the Consumer Financial Protection Bureau.

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