Debt settlement is a form of debt relief that is considered by financial experts to be extremely dangerous. The process often leaves consumers with damaged credit scores and can sometimes lead to even deeper debt. Perhaps the worst thing about debt settlement is the way it has hurt the reputations of good debt relief services like credit counseling and debt management. Because of the scams and dangerous practices in the debt settlement industry, many consumers are confused and less trustworthy of even the good guys! Luckily, we are here to clarify. We are going to review debt settlement in more detail, explain why it’s usually a bad idea, and show you what your other options might be.
What is debt settlement, anyway?
Debt settlement is the process of paying off debt to a creditor after mutually agreeing to a sum less than what is owed. Usually, only unsecured debt, such as credit cards and medical bills, is eligible for settlement. This can be done with the assistance of a debt settlement company or, in some cases, an individual may choose to do this on her/his own.
The Debt Settlement Process
We will cover the most common form of debt settlement—using a debt settlement company to act as middleman between consumer and creditor.
Here is how debt settlement usually goes. The consumer contacts a debt settlement company and enrolls in the program. The debt settlement company then has two goals. It needs to make the consumer’s financial situation look desperate (so that the creditor will settle) and it needs to create a large lump sum of money (making the settlement more convenient for the creditor and more likely to be approved).
To achieve the first goal, the settlement company will ask the consumer to stop making payments to the creditor. By doing this, the consumer is signaling to the creditor that “Hey, I’m in trouble here; I can’t pay you all this money.” In theory, this makes the creditor more desperate and more willing to settle. And from the creditor’s perspective, debt settlement can sometimes get more money back than selling the account to collections or losing out when the debtor files for bankruptcy. Keep in mind though, that settlement isn’t always with the original creditor; sometimes collectors or debt buyers will settle, too.
The idea here is to make your situation really desperate—not making payments, going beyond the charge-off period and other such practices are common. While this is going on, you might be asked to make regular deposits to the debt settlement company, in order to begin generating the lump sum. Essentially, you are being asked to put yourself in a dangerous financial situation and hope that it all works out. This doesn’t give you much control over your financial future and can have long-lasting consequences.
False Debt Settlement Promises
Most people who get “sucked in” to debt settlement end up falling for a false promise. Whether it’s an advertisement that promises to “settle your debt for pennies on the dollar” or an agent who claims to slash your balances in half, you should tread very carefully.
In reality, the numbers paint a much different picture. First of all, one recent study showed that approximately 80% of accounts are never settled. Those that are settled usually leave the consumer paying much more than promised, and only around 45% of those enrolled in settlement are able to complete the program (although some experts think this figure may be closer to 20%).
It’s important to be aware of these figures when considering if debt settlement is right for you.
Here is a video that explains how consumers are negatively affected by debt settlement promises:
Watch out for the Purported Attorney Model
As consumers have become more skeptical of debt settlement companies, a new trick has emerged. Attorneys and law groups have marketed “debt relief” services to consumers, only to outsource the consumer’s debt to third-party debt settlement companies. In some cases, the attorney’s goal is to get the client to sign a contract (which is really from the settlement company) and then have no future contact with the consumer. When these consumers need legal advice or representation in court, the attorneys are nowhere to be found. Several landmark cases of this type of fraud have been exposed in recent years, but it’s important to exercise caution when dealing with an attorney or any other entity offering “debt settlement” or “debt relief” and pressuring you to sign a contract.
Debt Settlement Fees
Upfront fees have been a major issue in the debt settlement industry. Basically, companies were charging for services they had not yet given and in some cases kept this money without ever settling the debt. The good news is that in 2010, the FTC banned the practice of charging upfront fees. This only applies, however, to for-profit debt settlement companies and those who offer their services over the phone. The rule was part of a telemarketing law and thus doesn’t apply to all settlement companies.
Debt settlement payment arrangements also put extra pressure on the consumer, and missing a payment could have catastrophic consequences. A former debt settlement employee explains the situation as follows:
“Other debt settlement companies will set up a savings account within their company, and the client is obligated to put a stipulated amount into savings every month. If they miss a month, they are canceled with no refund as per the signed contract.”
Not only can you lose your money by missing a payment, but you can also lose your money if the company goes under water. Not all debt settlement companies are on firm financial footing (go figure), and if they aren’t FDIC-insured your funds will go down with them.
So long story short, there are two basic fee structures for debt settlement:
- pay a percentage of your total debt (usually between 13-20 percent)
Example: you owe $50,000 and the settlement company charges 20 percent. You would pay them $10,000.
- pay a percentage of the amount of debt that is settled (as high as 35 percent)
Example: you settle a $50,000 debt at 50% ($25,000) and then owe the debt settlement company $8,750 (35% of $25,000).
Remember, some companies front load their fees, charging you significant money before doing any sort of service for you. And meanwhile, your creditors go unpaid.
(Here’s proof that this is happening, despite the FTC law: CFPB Takes Action Against Meracord for Processing Illegal Debt-Settlement Fees)
On top of this, most companies charge a monthly fee to be in their program. The National Foundation for Credit Counseling claims that this can be as high as $89 and predicts annual costs for a debt settlement program to be in the thousands.
There is one more hidden fee that people forget about. If you settle or are forgiven for a debt that is greater than $600, the amount will be treated as taxable income, and you will owe even more in April.
How does debt settlement affect your credit score?
Another big concern with debt settlement is the effect it can have on your credit score. Compared to other debt relief options, debt settlement typically has a much more negative impact. In fact, the NFCC warns that your credit score may drop between 65 to 125 points as a result of this type of program. Why might this happen?
First, you do damage to your credit score by intentionally avoiding payments to creditors. Depending on how the settlement company handles your situation, you could end up having the account charged off, defaulted, sent to collections, and so forth. This process can lead to a deteriorating score. And even after a successful debt settlement, your accounts are likely to be reported as “paid by settlement,” making you look even less reliable to future lenders.
The Pros and Cons of Debt Settlement
We’ve highlighted our biggest concerns with debt settlement, and there are quite a few. To be honest, there aren’t really any “pros” or advantages to debt settlement except for a small chance that it might work for you and get you out of debt (although you’ll likely have a credit score to rebuild). The infographic below summarizes the cons of debt settlement, for all you “visual thinkers” out there! Feel free to share it!
Alternatives to debt settlement
There are several alternatives to debt settlement. The first is the DIY method. You could use either the debt ladder or the debt snowball to pay off your accounts all by yourself. If you have a hard time with this, you could always reach out to the creditor, explain your situation, and see if you qualify for a hardship program.
There are some other options too. You could try to settle the debt on your own (without using an agency) or you could even try consolidation if you have multiple accounts. But these methods rarely work, almost never solve the underlying problem, and always present risk to you as a consumer.
Perhaps the best debt relief option is a debt management plan. Why? Because it encourages you to change behavior and become financially healthy, it does a better job of preserving your credit score, and you pay off everything you owe. To learn more about which debt relief option is right for you, try a free credit counseling session. In your session, a credit counselor will review your entire financial situation and give advice about your best options moving forward.