For many Americans who struggle with debt that would take years to pay off, relief could come in the form of debt settlement. However, the tricks of traditional debt settlement are sometimes hard to spot. Here we’ll explain what debt settlement is, how it works and five sketchy things to watch out for.
What is debt settlement?
For consumers who have past-due debts, debt settlement is a way to negotiate a lower settlement amount. That amount could be half or even less of what you currently owe. Once the agreed-upon amount is paid, the remainder of your debt is considered forgiven.
Here’s how it works: You or your representative negotiate a settlement payment with your creditors, paid in a lump sum or by monthly installments. The debt must be unsecured, such as credit card debt, medical debt or other loans made without collateral — not secured debt like an auto or home loan. Debts like taxes, alimony and student loans are also typically off the table for debt settlement plans.
Related article: How to settle IRS debt by yourself
If this sounds like the answer to your prayers, let’s take a look at some of the pitfalls you’ll want to avoid. Not all debt settlement solutions are created equal, and there are drawbacks to nearly every option.
The risks of debt settlement
According to the Federal Trade Commission, all debt settlement comes with risks, and many consumers wind up dropping out of their debt settlement plans without settling their debts.
Reasons for this include:
- The settlement process may take a long time and debt settlement companies often encourage customers to stop making all payments on debts. So, during this waiting period, you’ll likely accumulate more fees and penalties, which continues to damage your credit score.
- You could be sued by your creditors while you wait for the settlement to go through.
- Your credit score could take a major hit, both while you’re waiting to settle and then because of the settlement. (And it’s likely your score was already impacted by missed payments before your settlement process began.) Also, keep in mind that debt settlement usually stays on your credit report for seven years.
- Your payments toward settlement are usually held in a dedicated bank account, which will be administered by a third party. This may come with additional fees.
- If you saved more than $600 on the forgiven portion of debt, you will have to report that as income and pay tax on it, unless you’re insolvent.
Related article: How does debt settlement affect your credit score?
If that seems like a daunting number of negatives, we’re not quite finished yet. The Consumer Financial Protection Bureau (CFPB) cautions, “unless the debt settlement company settles all or most of your debts, the built-up penalties and fees on the unsettled debts may wipe out any savings the debt settlement company achieves on the debts it settles.”
So before delving into a settlement, you should do your homework, and that requires doing the math.
Choose the company wisely: 5 sketchy things to watch out for
1. Your creditors refuse to work with them.
When considering a debt settlement company, look at the types of debt they settle, their minimum debt requirements, and their minimum debt amounts per account. The CFPB warns that some of your creditors may refuse to work with the company you choose, so you’ll also want to research the companies for customer satisfaction. Also, check out companies with your state attorney general and local consumer protection agency.
2. Their fees are based on your total debt.
One of the most important factors to focus on is the fee, which is calculated based on a percentage of your debt. The percentages typically range from 15% to 25%, but pay attention to what amount that percentage is taken from.
Traditionally, debt settlement companies charge a percentage of the total debt you owe, while some debt arbitration services charge a percentage of the amount you save by settling.
This may not sound like a substantial difference, but when you run the numbers, it can be significant. Let’s look at an example.
- If you have $30,000 in unsecured credit card debt, and the debt settlement company charges 20% to 25% of your debt, that works out to $6,000-$7,500.
- If you have $30,000 in unsecured credit card debt and the debt settlement company charges 15% of your debt settlement, and you settled for $14,000, that means your savings are $16,000. The fee for 15% of $16,000 is $2,400.
“I would like to see everyone considering debt settlement complete the math all the way through, before committing to it as a way to get out of debt,” said Michael Bovee, the co-founder of alternative debt relief company Resolve, who has been working in credit and debt resolution for more than 20 years. “There are many instances where it just won’t make sense, or provide enough savings to justify the credit hit, risks of lawsuit and stress.
“A typical debt settlement company wants to sell you on the concept and their service. But when you add up what the settlements could be, along with their fees, and the taxes you may owe, you could end up paying close to what you owe today.”
It’s also worth noting that with the fee arrangement based on your settled debt, it’s in both your interest and your debt settlement company’s interest to have a bigger debt reduction.
3. They put their own interests over yours.
Another red flag: Some debt settlement companies prioritize their own interests over yours by paying off your debts in the order that gets them paid soonest. Meanwhile, interest and fees continue growing on the larger debts.
“This is very common,” Bovee said. “I talk to people regularly who have had a non-aggressive creditor account settled well before focusing on an account that has the highest likelihood of suing the consumer.”
4. They make baseless claims.
Consumers researching their debt options should also consider the following red flags outlined by the FTC. The FTC recommends avoiding any debt settlement company that:
- Charges fees before settling your debts
- References a “new government program” to relieve personal credit card debt
- Guarantees it will make unsecured debt go away
- Tells you to stop communicating with creditors without explaining the consequences, which can include lawsuits.
- Claims it will stop all lawsuits and debt collection communications
- Says that you can pay off your debt at pennies on the dollar
5. They don’t inform you of your rights.
One of the biggest tricks of debt settlement is what they choose to tell you and what they choose to NOT tell you. If you decide debt settlement is for you, know your rights:
- The company must advise you of the price and terms and any conditions for its services.
- When your payments are held in an external account, you are entitled to any interest they earn, and you can also withdraw the funds at any time without penalties. The administrator should not be affiliated with the debt relief company and should receive no referral fees. Your debt relief company is obligated to tell you this.
- If the company is settling for you with multiple creditors, it can only charge a portion of its fee for each settlement. It must tell you the percentage it charges and the estimated dollar amount that represents.
- The company must tell you how many months (or even years) it will take to make an offer to each creditor to settle your debt.
- If the debt settlement company requests that you stop making payments to creditors, it must advise you of the negative consequences that can result, such as credit score and credit report damage, you may get sued, and you may accrue additional fees and interest.
Debt settlement is not a deus ex machina. That is, it’s not a solution that magically appears and resolves all your problems painlessly. It’s a solution that may make sense in your case, with some trade-offs.
If, after looking at all the factors, you decide a debt settlement service isn’t for you, alternatives include credit counseling and/or debt management, debt consolidation, bankruptcy or direct negotiation with your creditors.
How Resolve can help
If you’re dealing with debt and not sure what to do, we’re here to help. Become a Resolve member and we’ll contact your creditors to get you the best offers for your financial situation. Our debt experts will answer your questions and guide you along the way. And our platform offers powerful budgeting tools, credit score insights and more. Join today.