Debt settlements are an attractive option to many consumers facing mounting debts, but they come with some serious consequences that should be weighed fully before making a decision. Here are 6 things to think about before opting for a debt settlement.
Many professional debt negotiators are targeting the areas hardest hit by the financial downturn and marketing their services. They make promises of big savings and debt reduction, but they often fail to mention any of the negative consequences of a debt settlement and downplay any of the potential risks.
Before considering a debt settlement, it’s important to understand some of the ways a debt negotiation can backfire on you:
- If your debt is settled for less than the full amount owed, the difference is treated as taxable income by the IRS. So if you owe $8,000 and settle the debt for $4,000, the $4,000 you save will be reported to the IRS and you will have to pay income taxes on that amount at tax time. Creditors generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt forgiveness over $600. This usually comes as a surprise to consumers who settle their debts, leaving them unprepared for the higher tax bill. Any debt settlement company that doesn’t very clearly warn consumers up front about the full tax consequences of a settlement shouldn’t be trusted. If you are considering a debt settlement, plan to talk with a tax professional about factoring the possible tax consequences of debt forgiveness.
- Some creditors sell the unpaid portion of a settled debt to a collection agency. Many consumers think they’ve knocked out their debt once and for all when they get a settlement, but creditors have been known to sell the unpaid amount to debt collectors. If that happens, you can expect to be harassed for a long time by debt collectors looking to collect the portion of the debt you didn’t repay to your original creditor. And if the debt collector gives up, the debt doesn’t just go away; they usually sell it to another collection agency, and the cycle begins again. To avoid that kind of scenario, debt settlement agreements must be written carefully and signed by the creditor with whom you are settling the debt. Because any misstep in drafting the settlement agreement can result in this never-ending cycle of debt collections, debt settlements are not to be entered into lightly.
- Debt settlements cause tremendous damage to your credit. Only bankruptcy causes more lasting damage to your credit report than a debt settled for an amount less than what is fully owed. One of the reasons settlements have an extra negative impact to one’s credit is that creditors won’t often settle a debt until a borrower is at least 3 months behind on payments. So in addition to the negative impact of the settlement to one’s credit, the 90 days or more of missed payments further drive down the consumer’s credit score. Just like disclosing the tax consequences of a settlement, any debt settlement negotiator should make it very clear up front that the settlement agreement will do lasting damage to the debtor’s credit report. Some debt settlement negotiators tell their clients to stop paying their bills and instead deposit money into an account to save up for a settlement offer. This ensures the settlement negotiator will be able to collect a fee, but it also increases the damage done to the client’s credit rating. This “funds accumulation” model of debt settlements has other consequences; it may inspire a lawsuit.
- Creditors may sue you. If you go too long without making any payments or acknowledging your creditors, they may very well pursue legal action against you. Whether or not they do so will depend on a lot of factors: How much is your debt? Are you judgment proof? Do you seem likely to declare bankruptcy? Even if there is no hope of recovering the amount owed, a creditor may still pursue a legal judgment obligating you to pay. This adds even more damage to your credit report, while giving the creditor more options to get paid, like garnishing your wages. If a debt settlement negotiator urges you to stop paying your debts and instead start depositing payments with them, you could end up on the wrong end of a lawsuit. Ask the settlement company if they keep attorneys on staff to represent you if following their advice gets you sued. A reputable company should be aware of this possibility, acknowledge it, and have a policy for protecting their clients.
- It won’t be cheap. If all goes well, debt settlements can save you a lot of money, but the settlement negotiator will charge hefty fees that you’ll have to pay even if the settlement doesn’t work out. Most professional settlement negotiators will charge the fees up front, so they get paid no matter what happens with your settlement. And when the companies have you send your payments to them instead of to your creditor, most won’t start saving for your settlement offer until they’ve collected the full amount of their fees from you. So months may go by before you even begin the process of working toward a settlement. In the meantime, the creditor you’re not paying will tack on extra fees and report all those missed payments to the credit bureaus. Those extra fees can include late fees, over-limit fees, interest and finance charges. All this is added to the original debt. So while the consumer expects to settle their debts at 50¢ on the dollar, the savings isn’t based on the amount of debt you start with, but rather the amount of debt you end up with when you’re ready to make a settlement offer. That figure can be significantly larger than your original debt, so you’re not saving as much as you might expect.
- Some operators in the debt relief services industry may use misleading marketing tactics. Some settlement companies have used dubious marketing and telemarketing to lure in new business. Concerns of players in the settlement industry making false claims about how much debt they can wipe out, how much it will cost, and how often they succeed in negotiating a favorable settlement for their customers have led to new FTC rules that may curb the worst of these abuses, but consumers should still be very careful when dealing with debt settlement negotiators and verify any claims that are made.
It’s good that consumers have choices available to them when facing their debts, from credit counseling to debt settlements to bankruptcy. But options like settlements carry many risks that should be weighed carefully before going forward. Any debt settlement negotiator who truly cares about their clients’ well being will discuss these risks thoroughly with new clients before they do anything else. Settlement operations that make glowing promises of big savings without mentioning any of the potential risks should be avoided.