Debt Help

Solving a Debt Dilemma with Debt Settlement

Stacy Johnson — Fri, 22 Jan 2010 15:00:03 +0000

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.

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This article is from Stacy Johnson of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Dealing With Debt: Credit Counselors

Stacy Johnson — Thu, 21 Jan 2010 15:00:02 +0000

If you're in debt trouble, get help.

I just published my third book about living debt-free. It's called Life or Debt 2010. To go with it, I'm doing TV news stories and writing blog entries that I hope will help you find extra money in your budget to pay off debt.

But this story is for people who can't think about embarking on a debt-destroying mission yet because their debt is currently destroying them. If you've got creditors calling, are behind on your payments, and basically just not making it, you need to find help, and the sooner the better. But what kind? There are three heavily-advertised options these days: credit counseling, debt settlement, and bankruptcy. (In fact, notice the Google ads all around this article right now!)

Over the next few days we'll take a closer look at each, starting with credit counseling.

Have a look at the 90-second news story below, then I'll go into more detail on the other side.

Credit Counseling

One of the first news stories I ever did 20 years ago was about credit counseling. Over the years I've done plenty more and have gotten involved with them in other ways as well: I'm on the advisory board of one local counseling agency, I've produced video and sold books to others, and several sponsor my news stories in various cities nationwide. Suffice to say this is a business I know quite well.

And they're a great way to get help with debts. There's no shortage of them out there, and many will help you for free. But look before you leap.

Open your yellow pages or look online for "credit and debt counseling" and you'll see lots of companies that seem to be falling all over themselves to bring you back from the brink of debt destruction. They're all over the TV and radio these days. Many wave the nonprofit banner like a flag and promise to reduce your interest rates, or even get the amount you owe cut in half. Some claim their services are free, or nearly free. So how do these things work?

Credit counselors typically help by putting you on a Debt Management Program, also known as a DMP. When you participate in a DMP, the agency is essentially getting between you and the people you owe, most often credit card companies. They contact your creditors and attempt to negotiate lower interest rates, get penalty fees waived and arrive at a monthly payment you can actually afford. Once your plan is approved, you send one check to the counseling agency every month and they divide the money among your creditors. It's not a quick fix — a typical DMP lasts three to five years.

Most counseling agencies give free advice, but if you end up in a DMP, you'll typically pay a small monthly fee to get it set up (0-$50) and monthly fees (5-10% of your debt payment, but normally capped at $25-$50).

But here's something important to know: the monthly fees these agencies collect aren't what keeps them alive. They're also getting paid by the banks whose accounts they're collecting. In years past the percentage they got was 10 to 12 percent of the debt. In recent years, that percentage has declined considerably, and some major banks have started handing out grants instead. Still, it's banks that supply the primary support for this industry, and historically that's largely been through debt management programs.

Why do you care? Well, since credit counselors make a large part of their income from putting you on a DMP, they obviously have a powerful incentive to do so. It could be a problem, since sometimes that might not be in your best interests. Other options, like repaying your debt without a DMP, or declaring bankruptcy might be better in some instances, but credit counselors don't get paid by recommending either.

That doesn't mean you shouldn't approach these folks. There are plenty of agencies that dispense honest, objective advice, including advice that ultimately doesn't pay them. But if you're not careful, you could get hooked up with a "DMP mill." These are companies that typically do a lot of advertising and put virtually everybody on a debt management program simply to make money. If your problem includes bills that don't qualify for a DMP (like a mortgage or car loan, for example) they won't help you with them. They also won't offer any type of budget counseling. And if your situation is so tenuous that bankruptcy should be a consideration? You'll never hear that suggestion from them.

For the DMP mill, it only takes a few minutes to sign you up for a program, and if you ultimately have to file bankruptcy anyway, who cares? You'll have wasted your time and tons of money, but they'll have collected their money for as long as you were able to stick with the program. And like most other credit counselors, they too are non-profit, lulling many into a false sense of security.

The way a credit counseling agency should work is that they should counsel you regarding all your debts and present you with all your options before you do anything that you can't undo. In other words, they should counsel you, not slam you into the only fix that makes money for them.

A quality credit counseling organization will also help with simple, free advice and other non-debt, credit-related issues. Here's an interesting story I did where a credit counselor helped untangle a credit card billing mess.

Specific Recommendations

I'd look for a credit counseling agency that belongs to one of two trade associations: the National Foundation of Credit Counselors (NFCC), or the Association of Independent Credit Counseling Agencies (AICCCA). I personally know many members of both of these organizations and in my experience, they're normally credible and well-intentioned. You can find NFCC members near you at their Find a Counselor Now page. You can find AICCCA members near you by using their state by state lists.

Full disclosure: as I mentioned above, my company has done work for members of both of these organizations. But rest assured, my recommendation is never for sale.

Are there other quality agencies that don't belong to either of these organizations? Most definitely. Dues for NFCC and AICCCA aren't cheap, and I also personally know agencies that don't feel like paying them, yet still maintain high standards. So you shouldn't necessarily assume non-members are bad. But wherever you go, ask questions before you agree to anything. Questions like:

What is the percentage of clients they have on debt management programs? If the answer is nearly all, that's bad. If the answer is about half, that's good, because it shows they're trying to help their clients with other methods.
What fees will you have to pay?
What amount of budget counseling you're going to get. If you're not going to get any tools to help change the way you deal with debt, you could end up in the same place farther down the road.
Do their counselors have any training and certification?
Is the agency accredited by an independent organization?
What will their help mean to your credit history? The correct answer here is, "There's no way to tell for sure. Could even be negative. But consider the alternative." The wrong answer is, "No problem, buddy! Sign here!"

Check the BBB or other online sources for complaints. And talk to more than one agency. When you talk to several, it's easy to distinguish between the ones that come across like used-car salesmen vs. ones that sound like what you're really looking for: an objective counselor.

Bottom line? If you can't see your way out of a debt disaster, definitely get help. And don't be ashamed or embarrassed to do so. More than a million people every year file personal bankruptcy. Millions more do nothing to try to help themselves and end up with ruined credit and lots of sleepless nights. Going to a pro for help may not be your proudest moment, but there are definitely a lot worse things that could happen.

Next time we'll be covering another heavily-advertised debt solution: debt settlement.

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This article is from Stacy Johnson of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: