The Debt Settlement Option: Myth Versus Reality

Debt settlement companies often claim that they can eliminate your credit card bills, settle your accounts for pennies on the dollar, and protect your credit score from the effects of filing bankruptcy. In some cases, they hold themselves out as the last, best option short of filing for bankruptcy. Of course, some companies are more legitimate than others. But the fact remains that the promises that are made do not always become a reality. Before deciding to hiring a debt settlement company, it is important to consider whether the promises are attainable.

The typical debt settlement model involves making a payment each month that goes into a savings account from which the company will negotiate with your creditors. However, before the money is deposited, the company will typically deduct certain administrative fees and costs which reduces the amount of the deposit available for negotiation. Recently, the Federal Trade Commission initiated a regulation that prevents debt settlement companies from charging for advanced fees up-front. For example, if a company settled a case for $1,000.00, there may be a 15% fee for the negotiation that allows them to collect $150.00. Rather than charge this amount up-front, the amount is now deducted at the time of settlement. It is important to understand when and how much you will be charged for debt settlement because the additional costs often consume the bulk of the funds that you pay towards trying to eliminate your debts.

You can negotiate a debt settlement on your own. It is not necessary, and sometimes not possible, to have a debt settlement company negotiate with your creditors. In fact, some creditors refuse to deal with these companies because of the fees they charge that could go towards debt payment, and because they don’t want a third party coming between them and their customer. Most collection agencies will offer some form of reduced settlement in order to clear the account from their books.

Not all debts can be settled for pennies on the dollar. They key to debt settlement is negotiation with creditors. Some creditors, however, may simply refuse to negotiate, or will only accept a settlement that pays 70-80% of the account balance. If you are not dealing with a hardship, such as a job loss or serious injury, then the ability to negotiate becomes less feasible. In order to encourage the creditors to negotiate, debt settlement companies may tell their clients to stop paying their bills so that the creditors have no option but to pursue costly litigation to collect. If the creditor refuses to respond to these tactics, then you may end up with an account that cannot be settled in addition to a lawsuit that may lead to a garnishment of your wages, or a lien on your home.

Debt settlement is not the only option. Sometimes debt settlement is suggested as the only alternative to filing bankruptcy. The truth is that if you have a hardship that prevents you from paying your debts, you may be able to request a forbearance from your creditors that will allow you to reduce or skip payments until you are financially able to resume repayment. Also, there are legitimate not-for-profit credit counseling agencies that may be able to negotiate a reduced interest rate on your accounts, rather than a debt settlement that drives you into litigation.

Debt settlement can ruin your credit score. Debt settlement companies will sometimes sell their program as a better alternative to filing bankruptcy based on the idea that it will have less of an impact on your credit score. This is seldom, if ever, true. If you are behind on paying your debts, have credit cards in delinquents status, facing litigation and lawsuits from not paying your bills, or have judgments entered against you, then there is virtually little difference between debt settlement and filing bankruptcy. In other words, your credit score may already be as low as it can go.

Debt settlement is not cheap. As mentioned above, debt settlement companies often charge administrative fees and costs, and additional percentages for successfully negotiating an account. However, if your creditor refuses to negotiate or accept less than an 80% settlement payment, requires payment for their attorney fees and costs for having to sue to collect from you, and your debt settlement company charges additional fees for servicing the account, then you may end up paying 100% of what you owe – if not more.

Debt settlement has tax consequences. Debt settlement companies do not always inform their clients of the tax consequences of getting a write off from a creditor. It is important to know that if you settle a debt for less than is owed, you may end up having to pay taxes to the government for the amount that was written off. For instance, if a creditor settles a $20,000.00 credit card balance for $8,000.00, they may write off the $12,000.00 on their taxes and file an IRS 1099 for $12,000.00 in your name. This is called a cancellation of debt, and the IRS treats the reported $12,000.00 as taxable income to you. In other words, settling a debt may result in your picking up a new creditor – the IRS.

Bankruptcy can be the better option. One of the things debt settlement companies count on is the perception that filing bankruptcy is somehow evidence of an individual’s moral or ethical failure. This begs the questions as to whether paying a balance on an account to a credit card company at 25% over 10 years is an ethical act. But the fact is that bankruptcy is a legal and legitimate option designed to help people and companies resolve their overwhelming financial problems to get a fresh start. Alternatively, the credit card companies are not hesitant to pursue their legal and legitimate options to collect their debts which consists of suing their customers and garnishing or levying their personal property. Putting the red herring of ethics aside, bankruptcy is a cheaper and more effective option for eliminating debt. It halts lawsuits and collection actions, and eliminates debts without creating any tax consequences with the IRS.

In 2010, the U.S. Congress attempted to pass the Debt Settlement Consumer Protection Act as a means of regulating the abuses in the debt settlement industry. The Bill apparently never made it out of committee, but versions of it have been adopted by various State legislatures around the country. In addition, many State Attorneys General have begun pursuing actions against the industry on the local level. These legislative and judicial actions highlight that the fact that there are abuses within the industry. Some debt settlement companies are more legitimate than others. But it is important to understand what is being offered, and what can be delivered. In some situations, the promises do not live up to the realities.

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