Debt settlement is a debt relief option alternative to debt consolidation. Debt settlement is not a form of debt consolidation. If anything, it is more similar to bankruptcy, since you are not paying 100% of your obligations (unlike with a Debt Management Plan) and your credit score will suffer negative consequences.
Debt settlement (also known as debt negotiation, debt arbitration, debt reduction, or credit settlement) entails negotiating to settle an account for a portion of the total principal amount owed. Debt settlement companies offer creditors a one-time lump sum for less than the full balance owed and have the rest of the debt forgiven. Each individual creditor can choose whether to accept or reject the settlement offer.
Under a debt settlement plan, you make monthly payments to an escrow-like bank account until (after typically 3 years or more), you will have deposited enough money for the debt settlement company to negotiate with your creditors and offer the accumulated funds for a reduced balance settlement.
"Abusive and harmful"
Debt settlement companies will typically charge advance fees and will ask you to stop paying your creditors. These practices have been defined as "abusive and harmful" by the U.S. Government Accountability Office.
Federal Trade Commission rules that took effect in 2010 have forbidden debt settlement companies from charging upfront fees only when the service is sold over the phone or over an online chat. If you sign up through a website or in person, a debt settlement company can still legally charge you advance fees.
Some debt settlement companies will charge you upfront fees and will collect these fees (in total or in part) through your first few months of payments. Effectively, these companies will ask you to stop paying your creditors and use that money to pay for their fee instead. So while you default on your debt, the settlement company will have earned itself (and collected) a high fee regardless of the fact that no settlement has been reached (or will ever be reached, since in an estimated 90% of cases the negotiation is unsuccessful ), nor that a contact with creditors has even been made on their part. Instead of an advance fee, other companies will charge a fee only after settlement is obtained ("contingency fee" or "back end" fee) based on a percentage (around 20%) of the amount they are able to settle. The 2010 FTC's Telemarketing Sales Rule has NOT forbidden companies from charging advance fees if they sell the service face to face or through a website, but only when they make the initial sale over the phone (or a web based chat) . It's easy to predict that companies will use the appropriate sales channel in order to legally charge the advance fee just as before.
Stopping payments can result in higher debt and lawsuits
Most debt settlement companies will ask you to stop making any monthly payments to your creditors because by defaulting on your debt you create the pre-condition of a settlement negotiation. In other words, if you have stopped paying them, there is a chance that your creditors will accept a lump sum settlement as a compromise solution, whereas if you continue to make regular monthly payments, there is no reason for them to accept a settlement. In addition, some creditors might sell your debt to a collection agency (or junk debt buyer) once you miss payments for several months (usually 6 to 12 months). Because the collection agency will have bought your debt for a fraction of the original balance, they will more likely accept less than the original principal amount, since they will be still making a profit. The problems with stopping payments are multiple:
- Credit damage - missed payments can show up for 7 years on your report even after the debt is settled.
- Collection process, wage garnishment, lawsuit - while your accounts are in default the creditor will start or accelerate its collection efforts, which can ultimately include filing a lawsuit against you in order to collect on the debt, winning the right to garnish your wages or put a lien on your property
- Higher debt - your debt will likely accrue late fees and see the applicable interest rate increase considerably as a penalty for the missed payments. This will increase your debt burden rather than alleviate it. To make things worse, debt settlement companies will usually start negotiating smaller debts first, allowing high interest rate to continue to compound on your larger debts.
If a settlement fails (in total or in part), as is the case in an estimated 90% of cases , you will find yourself dealing with a far worse situation compared to when you started: less money (if you paid an advance fee to the company), more debt, an even worse credit score, and an escalation of collection efforts against you.
Any amount you are able to save on your original debt balances might be treated as income and taxed. Creditors report settled debt to the IRS, which will consider it income unless your total debts are greater than your assets (valued at fair market), in which case you are "insolvent" and are exempt from paying taxes on settled debt.
Damaged Credit Score
Regardless of whether you are able to settle or not, your credit report will be damaged for years to come.
Low success rate
The typical outcome of a debt settlement process is that only a small portion of your debt will be settled, leaving you worse off compared to when you started. It is estimated than only 10% of debt settlement programs achieve the planned outcome. In many cases debtors have trouble making the monthly payments for the settlement program and drop out before a debt settlement is even negotiated.
The Better Business Bureau has been inundated with complaints related to debt settlement companies. People sign up thinking they will get an easy fix to their debt problems, only find themselves deeper into debt after having paid high fees.
- Fraudulent, Abusive, and Deceptive Practices Pose Risk to Consumers. United States Government Accountability Office (GAO). April 22, 2010.
- "FTC Issues Final Rule to Protect Consumers in Credit Card Debt". Federal Trade Commission (FTC). July 29, 2010.
- "#1 Threat to America’s Most Indebted Consumers: Debt Settlement Programs (According to Lawyers)." Steven A. Meyerowitz. LexisNexis. October 17, 2012.
- Beware of Bad Debt Settlement Companies. USA.gov