Everything I’ve ever read about debt settlement has been extremely negative and, for the most part, ugly. It’s because debt settlement is designed for people in very dire circumstances.
A friend of mine recently got into the debt settlement business since he was working with a lot of individuals in weak financial situations. We spent the better part of three hours discussing how debt settlement worked, why debt settlement made sense to some people, and why the business had such a bad reputation. My friend is a stand-up guy, I trust him, and so it was refreshing to hear about the business, warts and all.
In this Foundation series article, I hope to pass on some of that knowledge to you.
Please consult a lawyer and an accountant before making any decisions based on the information you read here.
How Debt Settlement Works
Here, in a nutshell, is how debt settlement typically works.
Who It’s For
You are behind on your debts and you are seriously considering bankruptcy as a way of getting yourself back on track. Bankruptcy itself is generally considered the nuclear option because it’s a mark that stays on your credit history for 7-10 years, depending on which one you declare. As you can see, debt settlement is not for someone who is a little behind on a debt they can otherwise manage. It’s for people in a difficult spot and looking for an option other than bankruptcy.
It’s generally believed that the debt settlement process can help you save 40-60% on your debts and the costs are approximately 15% your total debts. These are just ballpark figures I’ve pulled from across the web, some of which are offered by debt settlement companies, so your personal experience may differ.
Debt Settlement Process:
- The Setup: When you work with a debt settlement company, you stop paying your creditors and start paying into a trust account set up by the debt settlement company. Part of your payments goes towards fees and part of it goes towards an account that will then be used to pay off your creditors after negotiation.
- The Dark Waiting Period: The missed payments begin appearing on your credit history, your credit score drops, and creditors start calling you. Creditors typically write off debts that are over 180 days late, so as that date nears they become more and more anxious.
In addition to waiting for the creditors to get anxious, you have to wait for your trust fund’s balance to get high enough to pay down negotiated debts.
- Collections/Negotiation: At some point, the creditor will sell the debt to collections agencies for less than the debt itself. It’s somewhere at this point that the negotiation begins and it can start to get a little complicated so I’ll use an example:
Let’s say you owe $1,000. The creditor knows they can sell a debt to a collections company for $200, taking a $800 loss on the debt. If a negotiator says they would be willing to pay $500 to “settle” it, the creditor will probably take it. They get $500, rather than $200 for selling it to collections.
If it does go to collections, the collections agency bought it for $200 so they would gladly take an amount above $200 because it means they generated a profit off the bad debt.
Why The Bad Reputation?
Like with everything dealing with money, there are always scams. Debt settlement companies want to be the interface between you and the creditors, so they can negotiate down the debts. The problem with this process is that once communication stops, you can never be sure the debt settlement company is doing what they are promising. If they are simply collecting your money and not doing a thing, it’s very difficult for you to know. The best option for you is to review ratings with the Better Business Bureau, but even that is not guarantee.
Another reason they get a bad reputation is because debt settlement companies are expensive. They have to pay for the trust account, lawyers, and other administrative staff to manage the entire process, and we all know lawyers are not cheap! You’ll have to pay setup costs, monthly fees, and lots of other fees. This is where you really need to be diligent in reviewing what goes towards fees.
Risks of Debt Settlement
Beyond the risk that you’ll be ripped off, there’s always the risk that creditors won’t negotiate with a negotiator. As you stop making payments, the late fees and the interest and everything else piles up. It may get to the point where it will make sense for the creditor to sue you and demand that your wages be garnished.
Your credit score will fall. There’s no way around it. You will miss, by design, payments to creditors and they’ll report those missed payments to the credit bureaus. You’ll get 180+ day late marks, records indicating your debts went into collections will appear, and your score will plummet. If your score was already low because you were missing payments already, then the impact of this will be much lower. The reason why debt settlement is so appealing is because if you’re seriously considering it, chances are your credit is already lowered.
You Can Do This Yourself
In theory, you can negotiate and settle your debts yourself. With the recession, creditors know that people are in tough spots and you may be able to call up your creditors and negotiate down your debts. If you’ve missed a few payments to your credit card, the company might be anxious to salvage whatever they can from your account. Just know that if you succeed, your account will be closed.
In practice, it’s very difficult because you aren’t a lawyer. As much research as you may do, as much as I have personally read, it’s still a cat and mouse game to be played and neither one of us has experience in that arena. Also, creditors may not be interested in negotiating with individuals. However, it never hurts to call and try it for yourself, right?
Alternatives to Debt Settlement
Seek credit counseling. Credit counseling is something that people must attend if they want to declare bankruptcy and it’s something you may want to consider to help get you back on track. Credit counselors can help you repay your debts, rather than seek bankruptcy or debt settlement.
Bankruptcy. It’s an ugly word but it’s an alternative to debt settlement. The downside of bankruptcy is that it stays on your credit report for 7-10 years but generally it’s a more structured process with less fraudulent behavior involved. You will still have to pay fees, this time to credit counseling and bankruptcy lawyers, so it’s not a no-cost option.
Finding A Reputable Debt Settlement Company
I don’t know the answer to this but Todd Ossenfort, the Credit Guy at CreditCards.com advises that you choose a company that:
- Is accredited by The Association of Settlement Companies (TASC)
- Has certified debt arbitrators
- Has reasonable fees (shop around)
- Has a service guarantee
- Discloses what is included in your debt settlement program, including fees
- Is a member of the Better Business Bureau or area Chamber of Commerce
- Is licensed and bonded in your state, if so required
Do you have any personal experiences with debt settlement companies? If so, I would love to hear your feedback about the process. If you have any words of advice, things to watch for, or see errors in this post, please let me know!