Debt settlement is one of several things that may help you fix your debt problems. It may not work in all cases, and it could very easily make your credit problems much worse. But if you want to avoid bankruptcy, it’s a strategy that is certainly worth consideration.
What is Debt Settlement?
Debt settlement is a process in which you work with a debt settlement company to settle your debts for less than you owe. How? The debt settlement company negotiates a lower payoff balance with the creditor. Then you make the payments to the debt settlement company, which pays your creditors until all of the covered debts are paid.
This is different from debt negotiation in that a debt negotiation company has you make payments into a trust account and then pays the creditor in a lump sum at a reduced rate. They do it this way in order to help negotiate the lower settlement amount.
The debt negotiation company does not make regular monthly payments to the consumer’s creditors during the debt negotiation process either. This usually trashes your credit report, but at least it softens up the creditors.
What Debt Settlement Can Do For You
Debt settlement companies claim to be able to settle your debts for less than the full amount you owe. This is similar to what debt negotiation firms try to do. Sometimes they can negotiate a settlement at 50% of the balance. If they can do that well, it certainly is something worth considering.
How are they able to work this magic? Well, since reputable firms have experience in the debt settlement process, they may be able to work out settlement agreements with creditors more quickly and often on more favorable terms than what you could if you try do-it-yourself debt settlement.
Remember, a well-established debt settlement company often has working relationships with many creditors, including major credit card issuing banks. This not only gives them an advantage in working out settlement arrangements, but it often makes it possible for the debt settlement company to reasonably predict how certain creditors will respond to a settlement offer, as well as what can and cannot be worked out.
Why would a creditor even agree to work with a debt settlement company? After all, by participating in the settlement, they will get less than a full face amount owed.
They do it when they are convinced it is their best shot at getting paid albeit after taking a pretty sharp haircut. Creditors know that settlement is often the last step for a debtor before they file for bankruptcy. And if you file for bankruptcy, the creditors know they have almost no chance of seeing any cash at all.
On top of that, the creditor realizes that if they push you too hard and try to put you into collections, they’ll get even less. When you consider all this, creditors have plenty of incentive to participate in your debt settlement proposals.
How Does The Debt Settlement Company Get Paid?
Debt settlement companies are expensive. Their fee structures can be based either on a percentage of your total debt (which can be as high as 20%) or as a percentage of the amount of your debt that is actually settled (up to 35%).
What Debt Settlement Can’t Do For You
In order to get creditors to take you seriously, the debt settlement company will likely encourage you not to pay some or any of your bills. That’s going to trash your credit score friend.
On top of that, you’ll likely incur delinquent payment charges – adding even more to your outstanding debt. And if the creditor gets upset, they can always go after you in court.
And to make matters worse, you may even incur federal income tax liability. Here’s why.
When a creditor accepts less than full value for a debt, they can report the portion that has been forgiven to the IRS on Form 1099-C, if the amount exceeds $600. In other words, when they “forgive” your debt, its taxable income to you.
That’s right. You will have to add the amount of the forgiveness to your taxable income as it has been reported to the IRS. Naturally, this will increase your tax liability in the year that the 1099-C was issued.
Last, it’s important to understand that not all debts can be included as part of a debt settlement plan. Debt settlement generally covers only unsecured debt, such as credit cards and medical debts. Any loans that are secured by personal assets, such as car loans and mortgages, cannot be included in the plan. In addition, tax liens and student loan debts cannot be included in a debt settlement plan either.
What to Look Out For With Debt Settlement Firms
There are good debt settlement firms and poor ones, and a whole bunch in between. If you decide to use a debt settlement firm, keep the following in mind:
- Make sure that the debt settlement company has been around for more than a few years, and is generally well-regarded. Do a little due diligence and make sure to read any complaints leveled against them.
- Investigate to be sure that the debt settlement company is actually handling the settlement arrangements, and not subcontracting out to third parties.
- Avoid debt settlement companies that charge a monthly maintenance fee, in addition to percentage fees.
- Your credit score will take a hit if the creditor reports settlement as “creditor settled for less than the full amount”. It’s important that the debt settlement company negotiates inclusion of the term “paid in full” as part of the debt settlement, so that there will not be a negative credit entry.
- Be certain that all intended debts are included in the debt settlement plan.
- The debt settlement company should charge fees only after settling accounts (this is actually a legal requirement).
- Avoid firms that advise you to stop making payments on your existing accounts.
- Once you start a debt settlement plan, be sure to finish it completely – assuming you are working with a reputable firm. Early termination in the plan will undo everything you set out to do by participating in the first place.
- It is also possible, under certain circumstances, for a creditor to pursue additional legal remedies even after they have accepted a settlement for a lesser amount. A good debt settlement company will know the best ways to avoid that outcome.
Is Debt Settlement the Right Way for You to Fix Your Debt and Credit Problems?
Of course, it goes without saying that you have to pick the right firm to work with from the get-go. Otherwise, your situation could actually get worse.
If you do find a good outfit to work with, debt settlement can be effective if you have income to make the additional monthly payments to the debt settlement company, and if you have the commitment to see the plan through to the very end.
If you lack either ability, you might be better off talking to a bankruptcy attorney to see if that might be a better route to take.
Are you having problems paying your debts and keeping your credit scores up? Have you ever worked with a debt settlement company? What other methods have you tried to fix your credit problems?