If you’ve decided to pursue debt settlement to resolve delinquent credit card debt or other unsecured loans, be aware that there are costs involved. Depending on whether you engage a financial professional to assist in the process, the costs can be very low – especially when you factor in the reduction in principal you will secure if negotiations are successful. Even small debt settlement fees need to be factored into your decision making so you ensure the work and risk will be worth it.
The Costs of Using a Debt Settlement Company
Unethical debt settlement firms have earned a terrible reputation for leaving clients worse off than they were originally. However, state and federal governments have enacted a variety of laws in the past two years that prevent the worst abuses from occurring. Most of those laws resemble the limitations enforced by new amendments to the Federal Trade Commission’s Telemarketing Sales Rule. That regulation ended the popular practice of charging fees in advance and now only allows fees for settlements that have been satisfactorily completed.
- Debt settlement fees can alter how much you ultimately save.
- Learn the common costs associated with debt settlement.
- Don’t forget about the taxes that come with debt settlement.
For now, those federal rules apply only to debt settlement service contracts obtained or negotiated over the telephone. Unless your state has similar legislation in force for any contract, you can still pay outrageous advance fees without ever settling a debt if you are contacted by mail or respond to non-telemarketing advertisements.
The following example represents a typical fee structure for a debt settlement company and is based on attaining a 60% reduction in principal:
|Total Debt:||Current Mo. Minimum||Est. Settlement||Service Fee||Total Program|
|Est. Settlement:||40% of total debt||12 Month||24 Month||36 Month|
|Service Fee:||15% of total debt|
|Program:||36 months $458.33||$1,375||$687.50||$458.33|
|Months 1 – 3||ABC Debt Settlement Co. keeps the first three payments totaling $1,375 as an initial down payment for the services provided. The remaining service fee of $3,125 will be deducted in the next 15 months in installments of $208.33 per month.|
|Months 4 – 18||$208.33 of the incoming installment is applied to the service fee.
$250.00 of the remaining money is for escrow savings to negotiate with collectors
$458.33The service fee for representation is fully paid by the 18th month.
|Months 19 – 36||All money applied toward savings is held in escrow.At end of 36th month, the client has saved $12,000, and by now, all debts are settled.|
Do-It-Yourself Debt Settlement Help
The rash of bankruptcies in the current economy has made debt settlement a popular solution, and much of the mystery to the process has been clarified. Although professional firms certainly have more experience in negotiations with creditors and in drafting debt settlement agreements, many individuals have successfully settled debts on their own.
If you undertake debt settlement on your own, the costs in the above example do not apply, thereby leaving you with more money to apply to your debt. In fact, the only costs you would incur are for legal services to review and/or draft any communications you send to creditors and the final the settlement agreement.
Indirect Costs of Debt Settlement
If your credit score is not already bad, debt settlement will definitely have an additional negative impact on it. Most consumers will default on debt payments, out of necessity or in order to save money for the settlement offer, which will lower their scores.
However, your credit report will also note any settled debts, and other lenders will know the status of those debts. While settling the debt is better than a complete default, or worse, a bankruptcy, you should still expect to be denied credit or charged higher interest rates and fees for future loans.
The Tax Consequences of Debt Settlement
Any amount of debt forgiven by your creditor over $600 is considered taxable income by the IRS and most state taxing authorities.After completing a debt settlement, you and those taxing agencies will receive a Form 1099 from the creditor at year’s end, reflecting the total amount of debt forgiven. In most cases, you will have to pay income tax (although not Social Security and other self-employment taxes) on that amount. Some of the common exemptions from those taxes include:
- You are technically insolvent – i.e., your assets are less than your liabilities. An insolvent taxpayer does not have to pay tax on forgiven debt.
- The debt is in dispute. If you only agree to pay a reduced amount to settle a disputed balance, the IRS considers that settlement of a contested liability on which you do not have to pay tax.
- You have filed for bankruptcy protection. If you pay a portion of a debt as part of a bankruptcy proceeding, the IRS does not consider the forgiven amount to be taxable income.
- The debt is a student loan and was forgiven in return for qualifying public service.
Unless you qualify for an exemption, be prepared to pay income taxes on forgiven debt. And when considering whether to negotiate a debt settlement, factor those taxes into your decision. For the average consumer, saving 30 to 70% of the total debt amount is worth paying a 15 to 35% tax on those savings.