If you have listened to the radio for more than ten minutes in the last few months, you've likely heard at least one commercial for a debt settlement company. The commercials entice those of us with credit card debt by talking about "secret programs that the credit card companies don't want you to know about" to help you get debt free. This only works for unsecured debts (e.g. credit cards, medical bills) and not for secured debts like mortgages and auto loans or government debts like student loans and taxes. There's a good chance that there are some ads right on this page for debt settlement companies thanks to AdSense. Check out their web pages and incredible claims.
What they Do
When you contract with a debt settlement firm to assist you, they will assign a negotiator to your case. As part of your initial paperwork, you will sign a limited power of attorney form that will allow them to call your creditors and negotiate a settlement. Your creditors won't negotiate an account that is current, so the settlement firm will counsel you to not pay your bills during this time. Instead, they will tell you to deposit this money into an account to use for your settlement when the time comes.
If you started with your accounts current, you will need to wait until you are behind on your payments about three months before they begin negotiating. The negotiators will usually wait until you have enough money saved up to make payment immediately upon settlement. That means additional waiting. When your creditors call you to collect, and they will call to collect, you will have to endure their collection attempts and advise them that they need to discuss this with your settlement firm. If you haven't been through this, it isn't pretty. Debt collectors can be manipulative, threatening, and mean.
Upfront Fees
Debt settlement firms require payment for their services, and, no, it is not a pay-for-performance type compensation. If you choose to work with a debt settlement company, you will pay a fee based on the amount of debt you owe. This will be between 10% and 20% of your outstanding credit card balance. Firms will require you to authorize a monthly debit from your checking or savings account. They will let you spread this out for about 10-12 months, but you will be required to pay them in full before you settle your debt.
Debt settlement firms won't work with you if you have too little debt. Often, they will require at least $12,000 in credit card debt before they will work with you. Therefore, expect to pay a minimum of $1,500 in fees to the debt settlement firm for their services. If you are setting aside $280 each month to pay your debts, for the first ten months, $130 of that will be available to eventually settle your debts until the eleventh month. At that time, the full $280 each month would be available for debt settlement.
Nothing You Can't Do
If you genuinely cannot pay your debts, your credit cards can and will work with you. They understand that it is better to collect 50ยข for each dollar you owe, rather than going to collection and litigation. This will definitely test your mettle. They will try to get you to go on a payment plan before they settle, and that could be preferable. Even on a payment plan, they may forgive fees and freeze future interest.
Difficult Creditors
Not all creditors are created equal. Some are more aggressive than others. Many have sleazy collection practices. If you have a Discover card and ever too a cash advance or made a balance transfer, they will not settle your debt. American Express is another firm that is very difficult. If you work with a debt settlement firm and they tell you they can't help you with that debt after your fees have been determined or paid, be sure to demand a refund for that portion of your fees.
Hidden Costs
When you settle your debt rather than paying it, you will find there are a number of hidden costs. The one most likely overlooked when you're overwhelmed and scared is psychological. Your debt is a promise to pay, and when the dust settles, you know that your integrity has been compromised. As you go forward beyond the debt settlement, you will find that credit is harder to secure. Your other credit card rates may be increased, financing a home could be more expensive or difficult. Even your auto insurance rates could go up. That's because the debt settlement will appear on your credit report.
One expense your debt settlement company will likely fail to mention is that the IRS considers the amount of debt forgiven as taxable income. That's right. You will have to pay taxes on the amount forgiven. (See: IRS - Home Foreclosure and Debt Forgiveness). That means on April 15, after you settle your debt, you will owe the IRS about 25% of the amount forgiven as tax. If you can't pay that when it is due, be prepared for more penalties and fees. Remember, too, that the IRS does not settle on debt.
Bottom Line
Don't look to debt settlement firms as an easy way of getting debt free. Debt settlement is an option if you have a lot of debt and absolutely cannot pay. It's certainly better than going into bankruptcy, but its not a casual decision. Paying what you owe is the best route. Even if a debt settlement company delivers on a promise of getting you a settlement at 40% of the debt you owe, you will pay another 25 - 30% of the original debt amount as fees and taxes. By working with your creditors directly, you can save significantly by avoiding those fees. If, for some reason, you cannot work with your creditors directly, and you don't have someone you trust willing to negotiate on your behalf, don't contact a debt settlement firm thinking that it will be a quick fix. The road will be slow, difficult, and costly, but not as bad as bankruptcy.
On the road to a million, we're going to try to avoid this one.
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