With the rise of consumer debt, debt settlement firms are flourishing. Many companies advertise debt settlement as a quick fix to make bills disappear. While debt settlement can be a useful debt elimination tool, there are significant risks. Debt settlement is not for everyone. Before you hire a debt settlement company, educate yourself in order to avoid potential pitfalls.
(To learn more about negotiating with creditors and settling debts, visit our Debt Settlement & Negotiation topic page.)
People often confuse debt settlement with debt management plans.
In a typical debt management plan, the debt management company develops a plan for the consumer to pay off unsecured debts. Some creditors will agree to waive certain fees and reduce interest rates as part of the plan. The consumer makes a monthly payment to the debt management company. The debt management company then uses those funds to pay bills under the plan. (To learn more about Debt Management Plans, see Nolo’s article Debt Management Plans.)
In debt settlement, the creditor agrees to accept a reduced amount to consider the debt paid in full. The consumer hires the debt settlement company with the understanding that it will try to negotiate a settlement with creditors for less than what it is owed. In a typical arrangement, the consumer deposits funds into a designated bank account that the company administers.
Debt settlement companies have different fee structures, including:
Consider the following risks before signing with a debt settlement company.
Long-term financial commitment. Debt settlement companies often require you to deposit money into a designated bank account for a long time before they settle your debts. The account administrator may charge you a fee for account maintenance, in addition to its fees for debt settlement services. In many instances, it can take more than one year before there are sufficient funds to settle debts. Many people have trouble making these payments long enough to get any of their debts settled.
There is no guarantee that your creditors will agree to a settlement. Your creditors have no obligation to cooperate with the debt settlement company.
Your debt can soar, lowering your credit rating. Since settlement companies often encourage you to stop sending payments directly to creditors, your debts may continue to accrue late fees and penalties. Your credit report will reflect the non-payment of your debts.
No guaranteed protection from creditors. Hiring a debt settlement company to negotiate on your behalf does not shield you from your creditors. Creditors may sue you, and if they win, garnish your wages or bank accounts before your debt settles.
Negative tax consequences. Depending on your financial condition, any savings you get from debt relief services may be considered income and therefore taxable. There is an exception to this rule if you are “insolvent.” Consult a tax professional if are not sure whether you qualify for this exception. (See Tax Consequences When a Creditor Writes Off or Settles a Debt.)
The weakened economy has brought many disreputable debt settlement companies and scams out of the woodwork. Beware of a debt settlement company that:
If you have discovered a debt settlement scam on your own, file a report about the company with local consumer protection agencies, the Better Business Bureau, and your state attorney general office.
Debt settlement companies are rarely a good option. Before you pay for help, consider the following options:
If you decide to hire a debt settlement company, use extreme caution. Research the company with the Better Business Bureau. Find out:
The debt settlement company must disclose:
The debt relief company also must tell you that:
If you think debt settlement may be a good option for you, talk to a lawyer about it. Lawyers are bound by legal and ethical obligations to protect your interests. You may be able to hire an attorney to settle your debt for much less than you would wind up paying a debt settlement company. See our article on debt settlement companies vs. debt settlement lawyers.