Why You Should Avoid Debt Settlement Companies

Learn about debt settlement companies, why you should avoid them, and alternatives to using a debt settlement company.

Debt settlement companies offer to help debtors work out deals with their unsecured creditors to significantly reduce their debt load. These companies often claim they can negotiate lump-sum settlements that will cut your debts by half or more. Of course, debt settlement companies charge significant fees for these services.

In most cases, it’s best to avoid debt settlement companies altogether. For-profit companies that offer debt settlement services are often scammers that provide little or no help after you've paid them. Even if a debt relief company does settle your debts, you’ll be paying for services that you could have done yourself or would have better off paying to an attorney or a legitimate credit counseling company.

Read on to get information on how debt settlement companies work, why you should avoid them, and how to get reliable financial help.

What’s Debt Settlement?

Debt settlement is the process of negotiating with unsecured creditors to convince them to reduce the amount you owe on your debts and accept a lump sum in full settlement of the debt. To accomplish this, you can:

  • hire a debt settlement company
  • hire an attorney, or
  • act on your own behalf.

How Debt Settlement Companies Work

Debt settlement companies often claim that they’ll talk your creditors into settling your debts for pennies on the dollar. (Learn about other kinds of debt relief services and the laws that regulate them.)

Generally, a debt settlement company will sell its services by saying the following (or something similar): “You’ll make monthly payments to us and we’ll keep that money in a special savings account. Once you’ve accumulated enough money in the account, we’ll contact your creditors and talk them into accepting lump-sum settlements. You’ll end up paying much less than you owe on the debt. Usually, we’re able to settle debts for half of what’s owed, sometimes even less.”

This pitch usually sounds pretty good to debtors. But hiring a debt settlement company has many downsides.

Downsides to Hiring a Debt Settlement Company

Here are a few of the downsides to using a debt settlement company:

Downside #1: Your debt grows. As part of a debt settlement plan, the company will likely tell you to stop making payments to your creditors—including the accounts that you’re current on—and instead send your money to the debt settlement company to place in the special account. The company will likely tell you that your creditors won't settle unless you stop making payments But not making your payments just makes your debt problem worse. While your money sits in the ‘special’ account, perhaps for 24 to 36 months, your creditors remain unpaid. You get further and further behind, while interest, fees, and collection costs accumulate. In addition, your credit score will take a major hit and your creditors might sue you.

Downside #2: Your creditors might not settle. Your creditors don’t have to accept a lesser amount than they're owed, and many creditors won’t accept a settlement—especially if you’ve hired a debt settlement company. Your creditors might even step up their attempts to collect from you, like by filing lawsuits.

Downside #3: Debt settlement fees are typically high. Using a for-profit debt settlement company can be expensive. These companies often charge a set-up fee, a monthly fee, and a percentage of each settled debt (say, 25%), and they might pay themselves before paying any of your creditors. Or a debt relief company might simply disappear with your money. Even if the debt relief company actually works to settle your debts, it won't do anything that you couldn’t do for yourself for free. In almost all cases, you'll be better off negotiating debt settlements on your own, hiring a debt settlement lawyer to help you, or filing for bankruptcy, instead of hiring one of these kinds of companies.

Possible Tax Consequences

One thing to keep in mind is that settling a debt—no matter who handles the settlement process—could have tax consequences. The IRS generally considers canceled debt of $600 or more as taxable and settling debts for less than what’s owed can increase your tax liability depending on your tax bracket and the canceled amount. After you successfully work out a settlement with a creditor, expect to receive a Cancellation of Debt form (Form 1099-C) and, in most cases, you’ll have to include the canceled amount on your yearly return. Though there are some exceptions. (Learn more about tax consequences when a creditor settles a debt.)

Filing for Bankruptcy

In some cases, you might be better off filing for bankruptcy rather than working out settlements on your unsecured debts. Consider talking to a bankruptcy attorney to learn about the upsides and downsides of each option.

Getting Help

If you’re struggling financially and want to settle your debts, consider talking to a debt settlement lawyer. Make sure you’re hiring a legitimate law firm and not a debt settlement company masquerading as one. (Read about why it often makes sense to hire a lawyer if you want to settle your debts.) And, again, filing for bankruptcy might be a better option than debt settlement in your situation, so consider talking to a bankruptcy attorney as well.

Another good place to get financial advice is from an accredited, nonprofit credit counseling agency, like one through the National Foundation for Credit Counseling (NFCC). Legitimate nonprofit agencies offer financial counseling for free or for a minimal charge.

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