How Debt Settlement Works
Debt settlement differs from consolidation in that it does not result in the entire debt being paid. Debt settlement companies negotiate with each creditor to accept less than the total debt owed in return for an immediate, lump-sum payment. Naturally, creditors would prefer that you repay the entire debt, plus interest and late fees, so they will not typically discuss debt settlement unless:
- The debt is significant
- You are already several months behind on payments
- You have no apparent means to repay the loan
For creditors, debt settlement is almost their last resort for collecting the debt.
In response to consumer complaints regarding upfront fees charged by debt settlement companies, and one might assume, (based on the exemptions allowed) lobbying by the banking industry and bar association, the Federal Trade Commission recently enacted Telemarketing Sales Rule, or TSR, which regulates how for-profit debt settlement companies can market their services over the telephone. As a result, there are now three classes of debt settlement providers:
- For-profit providers
- Non-profit organizations
While the fees you pay will vary greatly between those three providers, the process is essentially the same. As with consolidation, the counselor assesses your financial situation; however, in this case, she looks for liquidity that can be used to make a lump-sum payment. Some counselors may suggest suspending payments on the debt and depositing the funds in an escrow account until the balance is sufficient for the lump sum and their fees.
The counselor contacts the creditor with your authorization to act in your behalf. In order to demand the highest concession from the creditor, you have to be prepared to declare bankruptcy if they refuse to settle. In general, large creditors are reluctant to except less than 40% of the original debt, and if you are employed, such that there is a possibility you could repay the debt in the future, they may not even offer that much.
Pros and Cons of Debt Settlement
Debt settlement can result in a substantial reduction in your debt, the avoidance of future interest expenses, and suspension of late fees and penalties. Those are great benefits, but there are huge risks as well. Most notably, you credit rating will take a major hit. In order to qualify, you have to be in default, and once you suspend payments in order to fund the escrow account, your score will drop again. Many consumers are never able to completely fund the escrow account and end up ruining their credit for nothing. If you paid an upfront fee, defaulting on the escrow payments means you wasted that money. Additionally, be aware that even if you are actively trying to negotiate a settlement, if you suspend payments the creditor can still file suit to collect and force you into bankruptcy. Even if you are successful in settling a debt, the amount of debt forgiven by the creditor is considered income by the IRS on which you will pay taxes unless one of the following applies:
- At the time the settlement was consummated, you were insolvent
- There was a bona fide dispute over the validity of the debt
- The debt was unenforceable by the creditor
Debt Settlement Fees
Typically, the fees charged by for-profit debt settlement companies are calculated as a percentage of the original debt. For instance, if you owe a credit card company $10,000 and the debt settlement company charges a 14% fee, you would pay a $1,400 fee. Other companies calculate their fee as a percentage of the debt forgiven, but typically charge a higher rate on that lower number. Attorneys may charge the standard hourly rates, a pre-set fee, or a percentage of the debt. Non-profit organizations can also vary greatly in their fees charged.
Who Will Benefit Most from Debt Settlement
Debt settlement is a viable solution for a consumer that is overwhelmed with unmanageable debt, lacks monthly cash flow to make debt payments, and has access to a lump sum of money – perhaps, from liquidating an IRA or receiving an inheritance. It is an alternative to bankruptcy, but one that should be considered carefully.