I’m shocked. Apparently, I’ve never written an article on the advantages and disadvantages of debt settlement and what to look for or watch for when you go to settle your debt.
If you want to talk to someone about your specific situation, I strongly recommend talking to my debt coach friend Damon Day. He is exceptionally good at helping people evaluate their overall situation and coming up with a comprehensive plan of action.
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So here goes.
The process of settling debt is age-old. It goes back to the time credit was first extended. It’s nothing new.
In fact, merchants have been settling their debts in reverse, turning outstanding accounts receivable into cash now using a process called factoring. This has been going on for ages.
Settling debt is simply the process of a debtor and creditor agreeing to resolve an outstanding debt for less than the debt’s face value. Cash in hand now is sometimes a higher value to creditors than waiting to be paid.
1863 – Read twice and referred to the Committee on the Judiciary. Reported by Mr. Trumbull without amendment, and with a recommendation that it be postponed indefinitely. A Bill Requiring the President to appoint commissioners to adjust, settle, and liquidate claims, accounts, and debts between the United States and any State, during the existing rebellion.
A very early example of how the United States government relied on debt settlement during the Civil War era.
What is new is the abuse of overselling debt settlement for an advance fee. Some companies intentionally offered the worst customer service to collect the advance fee and then have people quit. Other companies have taken the money, offered no service, and vanished.
Debt settlement also got a terrible reputation from the way it was sold. The GetOutOfDebt.org site is chock full of older posts with secret shopper calls and documentation that were examples of not telling consumers the truth to make the sale.
Most debt settlement salespeople were/are commissioned based. Their income is dependent not on doing what is right for the consumer but on whatever it takes to close the sale.
Desperate consumers in trouble are prime targets to mislead at times like these.
How to Avoid Getting Scammed When Getting Out of Debt
Debt Settlement Pros and Cons
Advantages to Settling Your Debt
Settling debt may be an appropriate thing to do in certain specific situations. So let’s talk about when debt settlement might be a good thing to consider.
You Have Cash on Hand to Settle – If you have about 50 percent of the amount of your debt on hand to make a lump sum payment if you can agree with your creditor, then you are in a good position to jump when the offer is right.
You Don’t Have to Raid Your Retirement Funds – If you have to borrow or take a withdrawal from your retirement accounts, I generally don’t think that is a smart thing to do. There are some limited circumstances when that might make sense though.
Chapter 13 Bankruptcy – If you cannot file a chapter 7 bankruptcy, the first thing you should do is get a second opinion from a different bankruptcy attorney. The vast majority of people can file a chapter 7 bankruptcy. But if the second opinion says you must file a chapter 13 bankruptcy if you file, then in some limited situations, settling your debt might be advantageous depending on the type of debt you have.
No Tax Liability – If you are insolvent when you settle your debt, you may not have to pay any income tax on the forgiven debt. Credit counselors get this fact wrong all the time when they try to scare people about debt settlement. Using IRS Form 982 the debt is forgiven up to the point where your assets exceed your liabilities can be tax-free. You must, however, file the form with your taxes.
Your Creditor Made You an Offer to Settle – Without doing anything, creditors make debt settlement offers every single day. Some of these offers are pretty terrific and allow people to make 1-12 payments on the agreed settlement amount.
Performance Fees – Companies that are compliant with the Federal Trade Commission Telemarketing Sales Rules do not charge a fee for their services until the consumer accepts the settlement offer made by a creditor and makes the first payment. However, even if the debt settlement company you are thinking of only charges performance fees, there is still a wide range of fees charged. Be careful.
Disadvantages to Settling Your Debt
Delinquent Debt – To get to the right people at the creditors with the authority and policies to settle your debt, you typically have to demonstrate you can’t pay your debt. Most people need to be 90 to 180 days past due to get to the right department.
Collection Calls and Threats – Once you fall about 60 days past due, the collection pressure will begin to increase, which can get very intimidating. The original creditors are not bound to honor and cease and desist letter to make them stop calling you. In fact, that can often accelerate creditor action against you.
Lawsuits, Judgments, Wage Garnishments – When you default on the terms of your credit agreement, a creditor can do all of the things they laid out in the agreement you signed. This can include suing you, winning, getting a judgment against you, garnishing your wages, or levying your bank account. However, in some states where you can’t get your wages garnished, but you can still have a judgment against you.
Big Hit to Your Credit – Falling behind on your payments will be reported to the credit bureaus. That negative history will remain on your credit report for seven years. Even when you eventually settle your debt, the amount of debt forgiven as part of the settlement is often reported as “charged off to profit & loss” and is a negative item as well.
You Don’t Have the Cash on Hand to Settle – If you don’t have the cash on hand to settle and you think you can save money to settle over a long period of time, you may be in for a rude awakening as your balances increase and more fees and penalties are added. The longer it takes to settle, the more at risk of being sued you become.
Most People Are Not Successful at Settling – Most debt settlement companies have not been historically successful at settling the majority of client debt. In fact, the historic debt settlement success rates are somewhere in the 10 percent range. This does not consider the number of consumers that only had a couple of debts settled, and not all. That being said, those few companies that screen incoming clients for suitability have some excellent success rates. But this is because they turn away many people that are not good candidates for settlement. For more on this, see The Truth About The Success Rates, Failure Rates and Completion Rates of Debt Settlement Programs.
Out of Statue Debt or No Wage Garnishment Possible – I’ve seen many companies sell consumers debt settlement services when the debt was not collectible to begin with. Either the debt was outside the statute of limitations, and the consumer could not be sued, or the consumer lived in a state where wages could not be garnished.
Cost – There is a wide variation in how much debt settlement companies charge consumers. This can vary from 20 percent of the enrolled debt to 15 percent of the amount saved. When you factor in the expensive programs’ cost, the actual savings experienced can be meager. However, some do it yourself programs are very cheap. Working with a debt coach to guide you through the process can be affordable since you will do all the work.
Time – Extended payment debt settlement programs don’t make any sense to me. For those who can file a chapter 7 bankruptcy, the debt, which is about 70 percent of bankruptcy filers, is eliminated in 90 days or less. After that, the credit can be quickly rebuilt, and people can be back to being qualified for new homes or cars before a 3 to 5-year payment debt settlement program is even over.
Tax Liability – If you settle your debt, the amount of debt above when you become solvent will be taxable as income. This is an additional expense that many do not factor in when calculating how much debt settlement will cost. The forgiven debt is reported to the creditor on a 1099-C form, and you will need to report all forgiven debt on your next tax return.
Not Applicable to All Debt – Not all debt is a good match for debt settlement. Debt that is secured by collateral is typically not going to settle. Unsecured debt is the most likely debt to tackle, but depending on the individual’s debt mix, just dealing with the unsecured debt may still leave the consumer in a bind and not solve the overall problem.
Loss of Retirement Savings – Settling or repaying your debt may not be a smart move for you, financially speaking. When you are younger, you have to rob future retirement to make payments, and when you are older, you are either robbing your retirement or diverting money you need to save for retirement. Want to know how many millions of dollars a debt settlement program may cost you in future retirement savings?
Advance Fees – Attorneys think they are exempt from the Federal Trade Commission’s rules banning advance fees for debt relief services. The Telemarketing Sales Rules prohibit charging consumers to settle their debt before the debt is settled. Attorney model companies feel they are exempt. When the fee is collected in advance of settling debt, this delays the settlement of the debt. Most often, this advance fee paid is not refunded to consumers if the consumer later must file bankruptcy or changes their mind about the program. With low program success rates and advance fees paid, most consumers in these advance fee programs will statistically kiss their money goodbye.
Not All Creditors Will Settle – There is nothing that forces a creditor to accept any settlement. If only a few creditors settle and the rest don’t, then all that is happened is that some money had been spent, but no total solution has been achieved.
Performance Claims – Debt settlement companies still make claims about the effectiveness of their service that are not open and transparent. Here are some examples of what you should watch out for and call the company to task if they try to hide their actual success rates.
May I base my advertising claims on the experiences of some previous customers?
Yes, but your sample must be representative of the entire relevant population of your past customers. To accomplish this, you must, among other things, use appropriate sampling techniques, proper statistical analysis, and safeguards for reducing bias and random error. You can’t cherry-pick the most successful examples to inflate your results.
If you advertise or represent that your customers will save a certain amount of money or reduce their debt by a certain percentage – for example, “We can settle your debts for 40% to 60%” – your statements must be truthful. You must have objective proof to back them up. Your claims must accurately reflect the results you’ve achieved for previous customers. It’s important to consider the message your claims convey. Under the law, the FTC looks at claims from the point of view of reasonable consumers. Therefore, what matters isn’t the literal accuracy of the words you use but rather your proof to support the “net impression” your message conveys. For example, claiming that your past customers have achieved “up to 60% savings” is likely to convey to new customers that they, too, will get savings of around 60%. If you don’t have solid proof to back that up, the claim is deceptive.
Here are several important requirements for making sure your savings claims are truthful and not deceptive:
- State the savings based on the customer’s debt when they sign up for the program. You may not inflate savings figures or percentages by including interest and fees the credit card company adds after a customer signs up for your program.
Example 8: Andy signs up with a debt relief service offered by Company H, owing $10,000 on his credit card. One year later, following negotiations with the credit card company, Company H negotiates a settlement allowing Andy to pay $6,000 to resolve the debt. However, since Andy enrolled, the credit card company has charged him interest and late fees totaling $2,000, so that Andy now owes $12,000. By getting a settlement for $6,000, Company H has saved Andy $4,000 ($10,000 minus $6,000) or 40% of the debt at the time of enrollment. It would be deceptive for Company H to claim to have saved Andy $6,000 ($12,000 minus $6,000) or 50% of his debt.
- Include the impact of your fees on the claimed savings. You may not inflate your savings claims by excluding the fees your customers paid you.
Example 9: Betty owes $10,000 on her credit card and signs up with Company J’s debt relief service. Company J gets a settlement allowing Betty to pay $5,000 to resolve the debt. However, at the time of settlement, Company J charges Betty a $1,000 fee for its work. It would be deceptive for Company J to claim to have saved Betty $5,000 – or 50% of her debt – because Betty also had to pay $1,000 in fees. Instead, Company J may truthfully state Betty’s savings as $4,000 ($5,000 minus $1,000) or 40% of Betty’s debt.
- In calculating the results you’ve achieved over time, you must include customers who dropped out or otherwise failed to complete the program. Don’t base your savings claims only on customers who completed your program.
Example 10: Company K had 10 customers signed up for its service. Each one had $10,000 in unpaid credit card debt for a total of $100,000. Five of the customers completed the program, and each saved $5,000 – for a total savings of $25,000. The remaining five customers dropped out of the program, each one still owing the $10,000 they owed when they signed up with the program. Taken together, Company K had saved its customers $25,000 – or 25% – of the total $100,000 debt they had when they signed up with the program. It would be deceptive for Company K to exclude the drop-outs and claim that it saved its customers 50% of their debt.
- Include all debts enrolled by your customers, not only those that have been settled successfully. In calculating your savings claim, you may not exclude accounts you failed to settle, even if the failure was due to customers dropping out of your service.
Example 11: Company L has 10 customers, and each of them enrolls two $1,000 debts in the program – totaling 20 debts or $20,000. Company L can settle 10 of the 20 debts, each for $500. However, it could not settle the remaining 10 debts before those customers either completed or dropped out of the program. Thus, Company L has saved its 10 customers $5,000 or 25% of their debts in the program. It would be deceptive for Company L to exclude the 10 accounts that weren’t settled and claim a savings rate of 50%.
Credit Counselors Lie About Debt Settlement – It’s a pet peeve of mine that credit counseling groups tend to be all fear-mongering about debt settlement and not offer it. The reason creditors don’t want them to, they’d rather you make monthly payments. When a nonprofit credit counseling company tries to scare people and use it as a sales tool, it is just not cool. See Does Credit Counseling Have a Fiduciary Duty to Mention Ethical Debt Settlement to Consumers?
Debt Settlement Companies Lie About Credit Counseling and Bankruptcy – Most of the debt settlement websites I’ve reviewed here either don’t have a real clue about the other viable options to get out of debt or makes claims about them that are grossly untrue. They sell their service as a way to avoid bankruptcy when the reality is that for most people, filing bankruptcy is the most logical and financially sound step to take to recover quickly.
Use the free How to Get Out of Debt Calculator to review all your debt relief options.
The Majority of Debt Settlement Companies Close – If we look at the history of debt settlement in the 2000s, it shows that the vast majority of debt settlement companies closed up before their client’s debt was all settled. This left consumers high and dry, counting on the debt settlement company being there for the long haul.
A Whole Lot of Scam Debt Settlement Companies – Sadly, there have been many debt settlement companies that I would call scams. The best thing anyone can do before signing up with any debt relief company is to read the following fee guides.
- The Ultimate Consumer Guide to Checking Out a Debt Relief Company Before You Sign On the Line
- 10 Must Do Steps to Find the Best Credit Counseling or Debt Settlement Company for You
- How to Check Out a Business or Company to Avoid Getting Scammed or Ripped Off
My Honest Review About Settling Your Debt Using Debt Settlement
In the interest of disclosure, in my past days as a debt relief provider I did settle debt for some clients. We had a flat fee success guarantee. The cost per creditor was $495 and if we were unable to negotiate a mutually agreeable settlement there was no fee. Experience proved to me that for the right consumer, settlement is a real possibility.
Screening and assisting the right consumer is the key to great success. That being said, the vast majority of debt settlement companies don’t properly screen incoming clients. They typically try to sell debt settlement services to anyone with a pulse, expressed a desire, or blindly believed the sales pitch.
There is no reason why a consumer has to pay high fees to settle their debt. If a consumer under the wing of a debt coach is a client of a DIY debt settlement company and is properly ready to settle their debt, they can do it themselves very affordably.
For the subset of the small niche of the consumer pool that is perfectly targeted for debt settlement, it can be a smart thing to do. But for most people, they need to review all their debt relief options first before leaping as if it is a magical solution.