The average American household had nearly $ 9,000 in credit card debt alone at the end of 2019 – and that was before the coronavirus pandemic devastated finances and caused sudden instability even for those who previously had their debts under control.
When you feel the pressure, it is important to carefully consider your debt management options. One of these options is to work with a debt settlement company – but according to personal financial experts, this is a strategy that comes with significant risks and disadvantages.
Here’s how debt settlement works and why it could hurt your finances in the long run.
What are debt settlement plans?
Generally, debt settlement plans involve negotiating with creditors to settle a debt for less than its current value. This lower amount can be paid as a lump sum or in multiple installments that can be negotiated either directly with the creditor or through an external debt regulator.
Michael Sullivan, personal financial advisor at Take Charge America, a nonprofit financial education organization, notes that while certain types of debt are eligible for debt settlement, others are completely excluded. As a rule of thumb, only unsecured debt is a candidate for debt settlement. Sullivan offers the following list as a more precise guide.
Types of Debts That perhaps Entitlement to debt settlement:
- Credit cards
- Retail and gas station cards
- Unsecured personal loans
- Short payouts for mortgages
- Car seizures
- Medical debt
- Private student loan
- Cell phone and electricity bills from closed accounts
- Rent payments from previous apartments
Types of Debts That are not Entitlement to debt settlement:
- Ongoing mortgages or rental payments
- Second or third mortgage
- Home Equity Lines of Credit (HELOCs)
- Federal student loans, like Sallie Mae
- Fines
- Child child support and child support ordered by a court
- Readjust
- Gambling debts
- Cell phone and electricity bills from open accounts
- Lease purchase agreements
How do I get a debt settlement plan?
Consumers looking for debt settlement information are often bombarded with advertisements from debt settlement firms. However, it is important to know that working with an agency is not your only option.
“One of the most misunderstood views is that you need a credit counseling or debt settlement organization,” said Susan Brown, CEO of First Connecticut Credit Union, Inc. However, it is not. While the process requires hard work and persistence, it is entirely possible to complete the debt settlement yourself by contacting creditors directly. Several banks, credit unions, and nonprofits also offer debt counseling services to help you explore all of your options.
Still, some consumers find value in the services that a debt collection agency offers. “The real value of debt settlement lies in the effectiveness of the negotiations,” said Sean Fox, president of Freedom Debt Relief, a national debt settlement firm. “The better the negotiations, the lower the severance pay.” For this reason, it is important to choose wisely when deciding to work with a debt collection agency.
Debt settlement firms will typically ask you to deposit a certain amount of money into a savings account each month that will eventually be used to pay the negotiated settlement amount, often after a period of two or more years. In the meantime, the company will negotiate on your behalf to lower the total repayment amount. But this service is not free. Most debt settlement companies make their money by either calculating a percentage of your total initial debt or the amount they’ll save you. many also charge monthly account management fees.
Risks of debt settlement plans
The main disadvantage of debt settlement plans is that there is no guaranteed outcome even if you turn to a debt settlement agency. While you wait for a solution – which often takes several years – you will suffer the consequences of missing payments. During this time, your creditors can still contact you and even sue you for non-payment, warns Sullivan. Additionally, “if accounts default during debt settlement negotiations,” he says, “it causes credit scores to drop significantly.” “Failures can stay on your credit report for seven years.”
It is entirely possible that you will accumulate fees, interest, and defaults only to find that your creditors were unwilling to pay themselves off. When this happens, you have effectively taken two steps forward and three steps back, and you are now burdened with even more debt than you started with.
Pro tip
Debt settlement plans can work for some people, but there are no guaranteed results and some significant risks. So you should try all your other options first.
How debt settlement plans affect your creditworthiness and taxes
One of the main criticisms of debt settlement plans is the long-term impact they have on your finances. Debt regulations go on your credit report and stay there for seven years, which can lower your credit score by as much as 100 points.
As Brown points out, paying your credit report creates additional hidden costs on top of the fees you’ve already paid to the debt collection agency. “The comparison has a negative impact on your creditworthiness, which in turn increases the interest rate on future borrowings,” says Brown. In other words, you will continue to pay for settlement in the form of additional interest for any accounts opened during those seven years.
Debt settlement also has tax implications. The IRS requires that you include the total amount of debt canceled as income on your tax return. This means that you may have to pay tax on the amount saved.
Debt settlement fraud
Debt settlement companies are tightly regulated, but not everyone abides by the rules. Debt settlement fraud is far more common than you might think. The Federal Trade Commission (FTC) warns of some warnings to look out for, including:
- Promise to pay off your debt for a percentage of your debt
- Collect fees before your debts are paid
- Failure to disclose the risks associated with debt settlement
- Ask to stop making payments to creditors without explaining the consequences
- Claim to prevent calls and lawsuits from debt collection agencies
- Advertise a “new government program” to cancel debt
If a company uses any of the tactics listed above, you should cut communications and report them to the FTC using this link.
How to choose a debt settlement company
There are ways to check the legitimacy of a debt collection agency. The FTC recommends checking with your state’s attorney general and consumer protection agency. These agencies can tell you if a company has any complaints and if it is properly licensed according to local regulations.
Fox has additional recommendations to ensure you are working with a reputable company. “Ask questions and expect answers,” says Fox. “The people at the debt settlement firm should be able – and available – to answer any questions you may have about debt settlement, your accounts, and their fees. If one company seems to have vague answers, look for another company. “
Fox also warns of so-called online reviews, which are actually paid advertising. When looking at review pages, check the fine print on the page for keywords like “sponsored content” or “ad” that indicate the review may not be legitimate.
To put this to the test, we searched the internet for the debt collection company CreditAssociates. The first result was a 4.5-star rating, which while initially seemed legitimate, contained a disclaimer that the review was sponsored by the company. It wasn’t until the second result that we found a link to the Better Business Bureau website, where we found the company had a B + rating and an average customer rating of 2 stars.
Our advice: Stick to reputable review sources like BBB for unbiased information on debt settlement companies.
Alternatives to the debt settlement plan
While paying off debts is a viable option for those months behind on their payments, it is not the only one. In some cases, credit counseling may be enough to get you back on track. Loan counseling services are offered free of charge by many financial education nonprofits and include personal mentoring with a qualified advisor. Before proceeding with any debt settlement process, it is a good idea to speak with a credit advisor to make sure that you have exhausted all of your other options.
Some people may also find that filing for bankruptcy is a better option depending on their financial situation. However, you must meet certain requirements in order to file for bankruptcy, such as a maximum monthly income. Bankruptcies also stay on your credit report for seven to ten years, depending on the type. This option can be discussed with a credit advisor to see if it is the right solution for you.
