Decoding Debt Settlement
Debt settlement companies promise to “reduce debt up to 70 percent,” “negotiate with creditors,” and “help avoid bankruptcy.” Their promises sound too good to be true. The truth is that while debt settlement agencies sometimes accomplish what they promise, it comes with a price.
Debt settlement is a form of debt arbitration. Debt settlement agencies negotiate with creditors to reduce the amount of the total debt a client is required to pay back. Once involved in a settlement program, clients are often advised to halt all payments to creditors and to cease all contact with creditors. The agreement with the debt settler will require that your monthly payments be sent to the settler to be held until there is enough “on account” to begin settlement activity. This action will cause your creditors to:
- Raise interest rates to penalty levels due to missed payments
- Charge fees for late or missed payments and over-limit fees as the balance grows
- Increase collection activity from letters and calls to involvement of collection agencies, attorneys and the courts, increasing costs
- Garnish wages once they have obtained a judgment
Debt settlement agency wait to begin negotiation until they collect enough monthly payments from the client to cover both their fee and the full amount needed in order to settle the first debt. It could take months until the first contact is made. While the client pays the settlement company, the creditors continue the collection cycle up to and including garnishment procedures. Account balances continue to grow due to interest and fees during this time. A $1000 balance could turn into a $1600 balance in six months with no payments when interest accrues at $24 per month and late fees are $38 and over-limit fees are another $38. A 50% settlement obtained on the $1600 balance would be $800. When the settler’s fee is added in there is not much savings in the end.
The negotiated debt is listed on credit reports as “settled” instead of “paid in full”. This listing will remain, often showing the balance still due, for seven years from the settlement date. This notation severely hampers the ability to obtain credit. Banks are not comfortable lending when there is a history of less than full payments. If the settled debt is greater than $600, the IRS considers this amount income and requires the creditor to report it as such. A 1099 form will be sent by the creditor to the IRS and the client to be included with that year’s tax return so that the income can be taxed. This can create a tax liability and in the example above it would be at least an additional $120.
Debt settlement should only be used by those that have a very poor credit rating already, don’t know how to negotiate settlements and do not have large amounts of debt. Debt settlement is something that the average consumer can do on their own and don’t have to “pay” a company for. With research, some saved money and a little time you can negotiate your own settlements with the creditors directly and save yourself some extra money.