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Updated on Thursday, January 19, 2017
If you’re deep in debt, you may have looked into getting some outside help to find relief. Frequently, your search for aid will bring you to debt settlement firms.
Debt settlement firms negotiate directly with your creditor to reduce your debt. If they succeed in settling your debt for a lesser amount, you will then be required to make one lump-sum payment, effectively wiping out your obligation.
Using these firms may sound like a lifesaver to someone struggling to pay off many debts at once. But debt settlement firms can actually cause more harm than good to your finances if you aren’t careful.
“Based on all the evidence we’ve seen, it is extremely rare that anyone benefits from using a debt settlement firm,” says Andrew Pizor, a staff attorney with the National Consumer Law Center.
Before you agree to work with a debt settlement firm, it’s important to know the risks:
5 Risks of Working with a Debt Settlement Firm
1. You will have to stop paying your debts. When you begin working with a debt settlement firm, many firms will encourage you to stop paying your debts and start paying into a third-party bank account. The idea is that you will eventually build up enough money in that account to be ready to make a lump-sum payment when the firm succeeds in convincing your lender or collections agency to settle.
This, of course, means that your accounts are going to become increasingly delinquent. It can take up to 36 months to fully fund a debt settlement firm account, according to the Federal Trade Commission.
While you are not paying your debt, your creditor can send your account to collections or even file a lawsuit against you before the settlement firm gets a chance to negotiate. You could also be responsible for any interest, late fees, and legal fees that have accrued over that time as well.
2. They may not succeed in settling your debt. Once you have saved up enough money to make a lump-sum offer to the creditor, the debt settlement firm will attempt to enter negotiations. What they may not tell you is that some creditors will not work with these firms as a rule. That means it’s possible that after you’ve saved enough money for the payment — meanwhile, allowing your accounts to become severely delinquent and your credit score to tank — you could be left without a resolution at all. To avoid this, call your lender or collections agency directly to ask if they work with debt settlement agencies before you sign up for their services.
3. They’ll take a portion of your debt savings. If the firm is able to successfully negotiate, they will often take a cut of your savings in return. For example, if you owe $10,000 and they are able to negotiate a lump-sum payment of $8,000 with $2,000 of your original debt forgiven, the firm would take a percentage cut of that $2,000.
4. Your credit will tank. It is important to note that debt settlement shows up on your credit report when it is reported to the credit bureaus. It will serve as a red flag to future lenders that in the past, you have not paid your debts in full. This could result in higher interest rates, smaller lines of credit, or even failure to get approved for credit at all.
5. You could face a hefty tax bill. If the amount forgiven is $600 or more, you will most likely have to report it as taxable income. Let’s look back at our earlier example. When that person settled their $10,000 debt for $8,000, the lender effectively forgave $2,000. To the IRS, that forgiven debt could be treated as additional income and you could owe taxes on it.
What to Look for in a Debt Settlement Firm
There are six things you should consider red flags when it comes to debt relief services, according to the FTC:
- The company charges any fees before it settles your debts
- The company advertises that they are part of a “new government program” to bail out personal credit card debt. There are no such programs.
- The company guarantees it can make your unsecured (credit card) debt go away
- The company tells you to stop communicating with your creditors, but doesn’t explain the serious consequences
- The company tells you it can stop all debt collection calls and lawsuits
- The company guarantees that your unsecured debts can be paid off for pennies on the dollar
Almost all states have some form of regulation for debt relief services. Some states ban them altogether.
A debt settlement firm may be licensed to operate in your state, but that does not mean they are necessarily the best for your needs. Because state licensing agencies are not federally regulated, quality standards can vary widely from state to state.
What should you look for, then?
A best-case scenario, according to Pizor, is finding a company that only takes a percentage of your debt reduction in exchange for their services. “This setup helps better align their interests with your own,” Pizor says. If you do well, they do well.
How to Avoid Debt Settlement Scams
Most debt settlement firms focus on unsecured consumer debt, like credit card debt. The most common scams in these situations involve telemarketing. You’ll receive a call from a company posing as a debt settlement firm that promises to reduce the amount of debt you owe as long as you pay an upfront free. They may even tell you that you don’t have to pay a fee until later as long as you’re saving money in a third-party account.
The latter sounds legitimate, but in both these situations, the supposed debt settlement firm can easily run with your money. There was a flurry of these telemarketing scams following the 2008 financial crisis, prompting the FTC to add further federal regulations under their Telemarketing Sales Rules.
If you can’t sit down with someone in person, it’s difficult to judge their legitimacy. In these situations, it’s best to just hang up.
Another tactic scammers perpetrate is using a lawyer as a front. This lawyer may be licensed to practice in your state, but will outsource your debt woes to companies across the country, or even the world, that have no legal background.
In order to avoid this scam, make sure you can sit down with the lawyer face to face in their office. Pizor recommends asking probing questions to get a feel for their legitimacy, including, “Who will be working on my case?”
If the lawyer or a paralegal in their office will be doing the work, that is much more acceptable than someone they cannot immediately supervise in person, or someone without a background in law.
Scams also frequently happen in the student loan sector. You’ll often see settlement firms advertising that there is a “new government program” that could help you settle your student loan debt. This is tricky because there are legitimate government programs that can help those with federal student loans defer payments or even forgive their remaining debt, but you should never have to pay anyone a fee in order to access these programs.
In late 2014, the Consumer Financial Protection Bureau prosecuted two companies that were preying on those with student loans.
Try Negotiating Your Own Debt Settlement
As long as you’re aware of the effect it may have on your credit, you can negotiate a settlement on your own. Many creditors have a floor for how much they’ll reduce your debt in favor of a lump-sum payment. This floor applies to debt settlement firms and consumers alike. By entering negotiations without a third party, you can save yourself the fees and potential victimization that you would risk by working with a debt settlement firm.
There are two important things to remember before you settle your debt:
- You will likely need to provide a lump sump payment right away. It’s unlikely a debt collector or lender will accept installments. Also, having the ability to make a lump sum payment could give you additional bargaining power.
- As we mentioned before: If the debt is settled for a lesser amount, you may be taxed on the portion of the original debt that was forgiven.
Consider Paying Your Debt in Full
Debt settlement leaves a scar on your credit report that will take years to fade. If possible, attempt to negotiate a lower interest rate and/or longer terms that may decrease your monthly payment. Just be aware that a longer term may lower your monthly payments but increase the amount of interest you pay over the course of your loan, even if your interest rate goes down or stays the same. However, you’ll more likely be able to afford your payments and possibly save your credit report.
That being said, some debts may have passed their statute of limitations in the state in which they originated. Once that statute of limitations has been passed, it is no longer possible for the lender or collections agency to sue you for those unpaid debts. Furthermore, they may have already fallen off your credit report. However, if you make any further payments, the clock will restart and the debt will be revitalized. Consult a consumer law attorney or a credit counselor before deciding whether to make a payment on an old debt.