Solving a Debt Dilemma with Debt Settlement
Debt settlement companies are advertising a lot these days on TV, radio and online: you've probably got debt settlement Google ads around this article right now. If you're in a jam, they might sound tempting. Should you bite? 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.
Imagine that I owe you some serious money, say 10 grand. I faithfully made payments to you when I first borrowed the money five years ago, but since then I've lost my job and moved away. Now the payments have stopped. You've called me over and over, but despite your harassment, you haven't gotten a payment from me in over a year.
Then out of the blue one day I call you up and say, “Gee, I’m really sorry about being such a jerk. But I'm still having trouble making ends meet. Here's what I propose: I'll borrow four grand from some other nitwit and send it to you today. If I do that, will you call it even? If you won’t accept that, I'll be forced to file bankruptcy and never pay you back at all.
You think it over and realize that $4,000 is better than nothing. So you take the money, remove me from your Christmas card list and head on down the road.
That’s debt settlement. It’s offering your creditor a lump sum of less than you owe to satisfy a debt.
There's nothing preventing you from doing this all by yourself. You can call the bank and offer to pay them less than you owe. Feel that you're not the best negotiator? You could ask a lawyer to do it for you: a bankruptcy lawyer would be a good choice. But there's another problem: you don't have the lump sum you need to even make an offer. There's where a debt settlement company comes in.
I recently visited a debt settlement company and interviewed both the owner and one of their clients. Watch the result below, then I"ll give you the back story on the other side.
As you just saw in that news story, the way most debt settlement companies work is to collect monthly payments from you every month. Then, after you’ve accumulated enough, they’ll make a settlement offer to the credit card company or other creditor on your behalf. So if you’re making payments to the credit card company now, the debt settlement company wants you to stop doing that and send it to them instead.
Good strategy? Well, if you’re not keeping up and have no hope of making your payments, it might seem logical. Furthermore, you might feel the bank deserves it, especially if part of the reason you can't keep up is because the bank's made your situation hopeless by jacking up your rate to 36% and piling on thousands of dollars in penalty fees.
But there are at least four problems with doing debt settlement this way.
The first is that you're thoroughly trashing your credit history and score by failing to make payments, not to mention ultimately paying less than you owe. You’d be pissed if I did that to you; banks are pissed when you do that to them. And they hit your credit score accordingly. The cost to your score, according to Fair Isaac (the company behind most credit scores), is 45-125 points. That’s a big hit, and one that's going to cost you big when you next need to borrow money.
The second problem is that when you settle a debt for less than you owe, you’re also creating an income tax liability. In the example above, when I paid you $4,000 to settle a $10,000 debt, the $6,000 I didn’t pay is what’s called a forgiven debt. And forgiven debts are taxable income. In other words, if you legally get away with $6,000 worth of debt, to the IRS that’s like earning $6,000; and that in turn could mean a bigger tax bill — $1,000 - $2,000 bigger, depending on your tax bracket. Add a thousand dollars to the $4,000 you paid to settle that $10,000 debt and now you're paying $5,000. But it doesn't end there.
The third reason I’m not enamored of debt settlement companies 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 ballooned by more than 50% 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 — they're making a bunch of money.
And one final issue with debt settlement is it's largely unregulated. And that could mean serious trouble. Even the owner of the company that I interviewed for my story above said so. As he pointed out, some agencies take major fees up front before they even begin to settle your debt. Some don't adequately disclose the fees or tax ramifications. Some have been charged with simply flat out stealing people’s money. And, as noted above, even ethical ones charge what I consider high prices for work that’s not rocket science.
I’m not going to say 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. And debt settlement could theoretically be appropriate for certain people in specific situations.
But you really need to be aware of the risks. The debt settlement industry is under investigation a lot these days. One example is a probe by the New York Attorney General’s Office. Check out the press release they issued about it.
So if you’re going to go down this road, think hard, read the fine print, 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.
- What fees are you going to charge?
- What taxes might I be responsible for?
- How is the money I'm sending you protected?
- How long have you been in business?
- How long will your program take?
- Are your fees front-loaded?
- What happens to my money if I drop out of the program?
- What happens to my money if you fail to settle the debt for an acceptable amount?
Bottom line? If you can borrow four grand to settle a ten thousand dollar debt, maybe from a relative or something, OK. But paying into a sketchy company for months or years, totally trashing your credit in the process, and paying major fees to do it? Not me.
In my next entry, I’ll talk about another option for those in trouble: bankruptcy.