How do traditional debt settlement companies make money?

A debt settlement company does exactly what its name implies: It helps you negotiate with your creditors to settle your debt for less than what you owe. Sounds amazing, right? Well, not so fast. You need to understand how traditional debt settlement companies work and, more importantly, how they make money to ensure that their goals align with yours. In order to make the best decision for your financial future, you’ll first need to weigh all the benefits — and risks — of settling your debt.

Debt settlement companies: Mind the fees

Let’s start with the biggest question: How much is this going to cost? Debt settlement companies (sometimes called debt relief companies) don’t work for free. They typically charge a fee of 20% to 25% of your enrolled debt if they’re successful in getting your debt settled for less. (Avoid any companies that try to charge you an upfront fee.) And because they take this fee no matter what — whether they’re able to lower your debt bill by a lot or only a little — their incentives may not match what’s best for you, says Michael Bovee, who’s been working in debt relief for more than 20 years and is the co-founder of Resolve, a company that helps people navigate their way toward financial health. 

“It doesn’t matter how good of a job they do,” Bovee points out. “They could do a very crappy job and still get paid the full fee. And that’s misaligned incentives.” 

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Many people don’t even bother to ask about fees upfront, says Bovee. The reason: Debt settlement salespeople are more likely to focus your attention on the reasonable monthly payment they’ll be able to secure for you. But the fees can make a good deal look not-so-great very quickly. Another factor: Depending on your situation, filing for Chapter 7 bankruptcy might be a better bet, but a debt settlement rep may not mention that. Why? They only make money if they settle your debt.

Do the math

Now that you know fees are involved, you’ll need to crunch the numbers. This will allow you to decide if working with a debt settlement company makes sense financially. 

Bovee gives an example: Assume you have $20,000 in credit card debt and you’re enrolled in a debt settlement program that lasts 48 months with an agreement to settle your debt at $13,000. You may owe about $4,000 in fees to the debt settlement company and, assuming you’re in a 20% tax bracket, $2,000 in taxes. (The IRS often taxes forgiven debt as income). Now you’re back up to owing $19,000, which means you only saved $1,000 spread out across four years. Which isn’t much.

While everyone’s debt settlement situation will look different, be sure to calculate what your savings will be after every penny is paid, including fees and taxes. In the end, while you’re being sold a “deal,” you may not come out much better than if you had simply focused on diligently paying down the debt yourself or negotiated with your creditors directly. If you choose to work with a debt settlement company, make sure you walk away with a clear understanding of your total costs before signing up.

Debt settlement companies: Read the fine print

Some debt collectors may advise you to stop paying your debts while they negotiate for you to save up a lump sum payment. Be careful — you’ll incur more late fees and interest fees and it may increase the chance of a lawsuit (more on that next), not to mention only increase your total debt balance. Plus, all those missed payments will do a lot of damage to your credit score.

Another risk of settling your debts is being sued for the debts you’re not paying. That’s one thing that Bovee says many clients assume is unlikely to happen to them. “I talked to two people today who were with other companies first,” says Bovee. “They’ll come to me and say, ‘Well, I’ve been with them for eight months, and they settled two of my debts, but now I’m being sued for the third and they can’t help me.’” 

Related article: Help, I’ve been sued by a debt collector!

Bovee says that many debt settlement companies typically start by settling debts with companies that they know are unlikely to sue. They’ll collect their fee for those before moving on to the tougher ones. A tough creditor might sue you and, at that point, the debt settlement company may not be able to help. “If you’re not paying creditors, some of them sue really quickly,” says Bovee. “Others wait. If your fees are 20% to 25% of the debt total, it means a two-year plan is now a three and a half year plan. This increases the likelihood of being sued because it’s taking creditors longer to be paid back.” 

While you may never be sued if you choose to go this route, know the risks and try to do your research on which companies are more likely to sue to weigh if settlement is a smart option.