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.)
Debt Settlement vs. Debt Management Plans (DMPs)
People often confuse debt settlement with debt management plans.
Debt Management Plan (DMP)
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:
- upfront fees
- monthly fees, where a portion the consumer’s deposits goes to pay the service fee, or
- a contingency fee, which is a percentage based on the amount saved through settlement.
Hiring a Debt Settlement Company Is Risky
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 Increase in Debt Settlement Scams
The weakened economy has brought many disreputable debt settlement companies and scams out of the woodwork. Beware of a debt settlement company that:
- Promises or guarantees to settle all your credit card debts for pennies on the dollar.
- Advertises a "new government program" to bail out personal credit card debt.
- Tells you to stop communicating with your creditors, but doesn’t explain the serious consequences.
- Tells you it can stop all debt collection calls and lawsuits.
- Charges high upfront fees before any debts are settled.
- Claims that it’s a fast, easy, and painless process.
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.
Is a Debt Settlement Company for You?
Debt settlement companies are rarely a good option. Before you pay for help, consider the following options:
- Working out an agreement directly with the creditor. (For tips on how to do this, see Strategies for Negotiating With Creditors.)
- Seeking help from a non-profit credit counseling center. You can find a credit counseling center near you at the National Foundation for Credit Counseling, www.nfcc.org.
- Filing for bankruptcy. (To learn more about bankruptcy, visit Nolo’s section on Bankruptcy Basics.)
If you decide to hire a debt settlement company, use extreme caution. Research the company with the Better Business Bureau. Find out:
- how many complaints it has received
- how the firm responded to complaints, and
- whether or not there are any recent government actions or lawsuits against the company.
The debt settlement company must disclose:
- the price and terms of service
- how long the process will take
- how much money or the percentage of each outstanding debt you must save before it will make an offer to each creditor on your behalf, and
- the potential negative consequences of not making direct payments to creditors.
The debt relief company also must tell you that:
- the funds you deposit are yours and you are entitled to the interest earned
- the account administrator is not affiliated with the debt relief provider and doesn’t get referral fees, and
- that you may withdraw your money any time without penalty.
Talk to a Lawyer First
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.