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Solutions to debt dilemmas: Debt settlement

Settle your debts for pennies on the dollar. Hype or hope? Let's find out.

By Stacy Johnson Jan 19, 2010 9:19AM

Debt-settlement companies are advertising a lot these days on TV, radio and online. Their ads will say something like “Reduce your debt balances 40-60%! Be debt-free in 12 to 36 months!”

 

Sounds tempting, but is it worth it? I’d be super careful

 

Here’s an excerpt from my latest book, "Life or Debt 2010," about what debt settlement is, how it works, and whether it’s a good idea.

 

Say I’ve owed you $10,000 for the last five years. I made payments to you when I first borrowed the money, but then I lost my job, moved away, and long ago the payments stopped. Despite your best efforts, I haven’t paid you a dime in more than a year. Then one day I call you up out of the blue and say, “Gee, I’m really sorry about not being able to pay you back. Tell you what: If I send you $4,000 today, will you call it even? If you won’t, I’ll just file bankruptcy and never pay you back at all.”

 

Odds are that when you think it over you’ll realize that $4,000 are better than none. So you’re likely to either counter back with some other offer or take the four grand and go on down the road.

 

That’s debt settlement. It’s offering your creditor a smaller lump sum to pay off a debt. You can do this yourself, and people do. You simply call the bank and go through a process similar to the one above: Offer to settle the debt in full by paying a portion of it right away and in a lump sum.

 

But if you want help with this process, you won’t find it at credit counseling agencies. They’re in business to collect the debt in full, albeit at more favorable rates and a longer potential payback period. So if you’d rather pay back only part of your debts, and want to hire help, you can go to a lawyer (a bankruptcy lawyer would be a good choice) or you can hire a debt-settlement company.

 

Here’s a news story I did on debt settlement. Watch it, then we’ll go into a bit more detail.

 

 

How debt settlement works

If you have a lump sum of cash that you can send to a creditor to settle a $10,000 debt, fine. Call them up and make them an offer, or have a lawyer do it.

But as you might imagine, most people who find themselves in this position aren’t sitting on a lot of cash. So where do they get it? As noted in the story above, the solution you’ll hear from most debt-settlement companies is to make monthly payments to them every month. After you’ve accumulated enough, they’ll make a settlement offer to the credit card company or other creditor on your behalf. 

 

If you’re making payments to a credit card company now, the debt-settlement company wants you to stop doing that and send those payments to them instead.

This could be a good strategy, at least theoretically. Granted, you’re obviously screwing up your credit history in a major way when you stop making payments on your debts. But if you’re not keeping up and have no hopes of making full payments -- especially if part of the reason is because the bank has jacked your rate up to 36% and piled on thousands of dollars in penalty fees -- this is a way out.  But there are at least four problems with doing debt settlement this way.

 

The first is that, as noted above, you’re obviously not helping your credit history by failing to make payments and ultimately paying less than you owe. You’d be ticked if I did that to you; banks are ticked when you do that to them and your credit score will take a hit accordingly. The cost to your score, according to Fair Isaac (the company behind most credit scores) is 45 to 125 points. That’s a major ding.

The second problem is that when you settle a debt for less than you owe, you’re also creating a tax liability. In the example above where I paid you $4,000 on a $10,000 debt, the $6,000 or so I didn’t pay is what’s called a forgiven debt. And forgiven debts are taxable income. In other words, to Uncle Sam that’s like earning $6,000, and that in turn could mean a tax bill of $1,000 to $2,000 next April. Which means that instead of paying $4,000 to settle that $10,000 debt, you really paid $5,000 or more depending on your tax bracket.

The third reason I’m not enamored of debt settlement is the fees they charge -- typically 15%, not of the amount you actually paid to settle the debt, but the amount you owed. In our $10,000 example, that’s adding another 15% of $10,000, or $1,500. So if we settled for $4,000, paid $1,000 in income taxes and $1,500 to the debt-settlement company, now our total tab has swelled to $6,500.

 

To me, $1,500 seems a high price for doing something that’s pretty easy -- calling a bank and offering them less than what you owe. That’s probably why the debt-settlement industry advertises so heavily: It's a lucrative business.  

 

And last but not least, the debt-settlement industry, unlike the credit counseling industry, is largely unregulated. That means there are more than a few bad apples. Some agencies take major fees upfront before they even begin to settle your debt. Some have been charged with flat-out stealing people’s money. And, as noted above, even the ethical ones charge what I consider high prices for work that’s not rocket science. 

 

I’m not going to say in black-and-white that you should never, ever deal with any debt-settlement company. After all, it’s possible that there’s a really great one out there somewhere. 

 

But let me share a true story with you. You just saw the news story I did about debt settlement. While I did get the story done, it was very, very difficult to get any debt-settlement company to go on camera. And one of their national associations refused to comment at all for this story. In 20 years of TV news I’ve never had that happen in any industry.  

 

In order to finally get someone to interview, I had to call at least a dozen companies. I even called a guy I’ve known personally for years who works at one of these companies and has assured me many times that his company is totally reputable. Maybe, but they weren’t willing to go on TV to say so. 

 

While all that may not mean much to you, it speaks volumes to me. Think about it: If you owned a business and had the opportunity to extol your virtues to 10 million viewers absolutely free, wouldn’t you jump at the chance? When I do stories that involve credit counseling agencies or bankruptcy lawyers, they certainly do. 

 

The debt-settlement industry has also been getting negative press lately. One example is an investigation by the New York Attorney General’s Office. Check out the press release they issued about it here.

 

Suffice to say I’m leery of debt-settlement companies. Since it’s possible that there are good agencies out there and debt settlement might work for a select few, I’ll stop short of telling you to run the other way. But I’d be very careful.  

 

If you’re going to go down this road, think hard, read the fine print, and check with the BBB, state consumer protection agencies, complaint sites and any other place you can think of.

 

And ask a whole lot of questions first, like:

  • The fees they’re going to charge.
  • The taxes you might have to pay.
  • How the money you’re letting them hold on your behalf is protected.
  • How long they’ve been in business.
  • How long the program will take.
  • If their fees are front-loaded (that is, is the first money you’re sending in going to pay fees, or going to settle the debt?).
  • What happens to your money if you drop out of the program?
  • What happens to your money if they fail to settle the debt for an acceptable amount?
  • If there’s a lawyer involved, check that person's credentials and complaint record with state agencies.  

In my next entry, I’ll talk about another option for those in trouble: bankruptcy.  

 

Related reading at Money Talks News:

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