What Debt Settlement Companies Do and What to Watch Out For[yoast-breadcrumb]
What Debt Settlement Companies Do and What to Watch Out For
If you’re struggling with high credit card or other unsecured debt, debt settlement may sound like an appealing option. Debt settlement companies make big promises that they can slash your debt by negotiating with creditors on your behalf. But there are huge risks to using these services. This article will explain how debt settlement works, pros and cons to consider, and what to watch out for with debt settlement companies.
How Does Debt Settlement Work?
Debt settlement involves stopping payments to creditors, letting your accounts go delinquent, and waiting for creditors to agree to settle for a fraction of what you owe. A debt settlement company will advise you to stop paying your credit card and other unsecured bills and instead make monthly payments into an escrow-like account. Once there’s enough money in the account to make a settlement offer, the company will contact your creditors and attempt to negotiate a deal. If the creditor agrees, you pay the settlement amount and the account is considered “settled in full.”
Settling debt for less than the full amount owed has consequences. Your credit score will plummet, creditors can still sue you, and any forgiven debt may be taxable income. Debt settlement companies typically charge hefty fees based on a percentage of your enrolled debt, ranging from 15% to 25%. This covers their services plus the escrow account. There is never any guarantee creditors will accept a low settlement offer.
The Pros of Debt Settlement
If debt settlement works as promised, the benefits are:
- Lower payments. Your monthly payment to the debt settlement company is likely less than minimum payments on all your credit card bills.
- Settled for less. If creditors accept the deal, your debt burden will be lightened.
- One payment. You make one monthly payment to the debt settlement company instead of juggling multiple credit card bills.
- Avoids bankruptcy. Settling debt is likely better than filing Chapter 7 or Chapter 13 bankruptcy.
The Cons of Debt Settlement
There are also downsides to understand:
- Huge fees. Debt settlement companies charge 15% to 25% of your debt in fees. These fees are front-loaded so companies still get paid if you drop out.
- Credit damage. Your credit score will plummet and creditors may sue you before any debts are settled.
- Tax consequences. The IRS may count forgiven debt as taxable income.
- No guarantees. Creditors are not obligated to accept lowball settlement offers.
Debt Settlement Risks and Drawbacks
Before you sign up with a debt settlement company, be aware of these hazards:
- Fees paid upfront – Debt settlement companies usually charge their full fee upfront before settling any debts. If you don’t complete the program, you lose the money.
- Lawsuits from creditors – Once you stop paying your bills, creditors can sue you. The debt settlement company is not responsible for representing you in court.
- Ongoing late fees and interest – Your debt continues growing as creditors tack on late fees and penalty APRs.
- Settlements may not happen – There’s no guarantee creditors will accept lowball settlement offers. They may refuse to negotiate at all.
- Tax consequences – If a creditor forgives $600 or more, that money could be taxed as income. You’ll get a 1099-C form.
What to Look for in a Reputable Company
If you understand the risks and still wish to pursue debt settlement, choose a reputable company that:
- Is licensed in your state – Check with your state attorney general to verify licensing.
- Explains program details in writing – Get contract terms, services, fees, and risks in writing upfront.
- Charges fees based on settlements – Avoid companies that charge the full fee before settling any debts.
- Has a solid refund policy – In case you want to cancel the program.
- Is accredited by industry organizations – Like the American Fair Credit Council.
Alternatives to Debt Settlement Companies
Debt settlement is risky and not a magic bullet. Consider these options first:
- Credit counseling – Nonprofit credit counseling provides free budget and debt advice.
- DIY settlements – You may get better deals negotiating directly with creditors yourself.
- Debt management – Credit counselors can set up reduced interest debt repayment plans for you.
- Bankruptcy – Chapter 7 or Chapter 13 bankruptcy may be better than debt settlement.
- Debt consolidation loans – Consolidating with a lower-interest loan avoids settlement risks.
The Bottom Line
Debt settlement seems like an easy fix but can seriously damage your finances and credit if things go sideways. Thoroughly research any debt relief company before signing up. Often times, DIY debt settlement, credit counseling, debt management plans, or even bankruptcy produce better results than risky debt settlement programs.