Debt Settlement Could Cost More Than You Think

If you're drowning in unpaid bills and desperately looking for a way out, chances are you've come across an offer that sounds something like this: For a fee, a professional debt-settlement company will help rid you of your debt for as little as half the amount you owe.

Sounds like a scam? Or like you're finally getting the break you deserve?

The answer may surprise you. Debt settlement is, in fact, a perfectly legal solution for consumers who are in deep and seeking an alternative to bankruptcy. But having a debt-settlement company do the legwork for you is fraught with risk, not to mention outrageous fees.

Here's what you need to know about debt settlement and the companies that claim to do it for you.

The basics

It's a little-known fact that when you fall further and further behind on your payments, creditors would much rather agree to settle your debts than have you file bankruptcy and not get paid at all, says debt expert Gerri Detweiler, author of "The Ultimate Credit Handbook." In exchange for an agreed-upon one-time payment — typically, between 20% and 75% of what you owe — the creditor forgives the rest of your debt and starts reporting it to the credit bureaus as settled.

Meanwhile, you'll need to put money aside towards the settlement and stop making payments to your creditors. On your credit reports, the balances of settled debts will show $0. However, any previous history of delinquent payments or charge-offs will remain on your report.

Not surprisingly, creditors don't like to advertise debt settlement. They also make it an extremely difficult solution to pursue. As a rule, creditors won't negotiate with consumers who are current on their bills, often refusing to discuss settlements unless you're at least three to six months behind, explains Detweiler.

That means dodging collections calls while trying to save up the cash for a settlement. If you're working with several creditors — you'd typically tackle the debts one at a time as you collect the money to pay them off — it's hard, if not impossible to know which creditor might agree to settle earlier than others. "There's an art to it," Detweiler notes.

The problem with debt-settlement companies

With that in mind, it would be great to have an experienced, knowledgeable debt-settlement company hold your hand through the process, right?

Not really. Once you sign up with a company, chances are you'll pay dearly for those services, says Deanne Loonin, a staff attorney with the National Consumer Law Center (NCLC), who has investigated the practices of debt-settlement companies.

Outrageous fees

Just how much will you pay? Good luck finding that out. "I've never seen a company that's given a straight answer," says Loonin. The industry's fees and fee structures are all over the place. Some companies charge a percentage of the total debt — typically 15% or 18% — that's paid before you start accumulating savings.

Others charge a percentage of the debt savings — usually 25% — once you settle, plus an initial sign-up fee and monthly service charges. Then there are those that charge a flat monthly fee throughout the length of the program.

Even the industry admits figuring out the costs is a challenge. "I have seen every kind of [fee] model you can think of," says Jenna Keehnen, executive director of The United States Organizations for Bankruptcy Alternatives (USOBA), an industry trade group. "It's very confusing."

Worse than confusing, it's prohibitively expensive, says Katie Porter, a professor of bankruptcy law at the University of Iowa. She recently came across an offer to settle $33,551 in debt that projected a $5,032 service fee that was to be paid in monthly installments. Only after the service fee was paid off two years later, did the client actually start saving for the settlement. "That $5,000 buys a substantial amount of attorney time," she says. "You can get a consumer [or bankruptcy] attorney to represent you and help with your debt problems for a lot less than that."

Questionable services

What does a debt-settlement company do for you? In theory, it's supposed to help you negotiate your debts. In practice though, that doesn't really happen, says Porter. During the two or more years that you're saving money — typically in an escrow account that the debt-settlement company has access to — the company does nothing but withdraw fees.

"A lot of consumers think they've taken care of the problem after contacting a company, but the reality is the debt-settlement company hasn't settled anything in the beginning," Porter says.

The companies also claim that they'll help you dodge collections calls. But referring collections calls to your debt-settlement company often backfires, says Leslie Linfield, executive director at the Institute for Financial Literacy, an organization that provides prebankruptcy counseling.

"Many creditors, once they know a client is working with a debt-settlement company, will escalate the account," she notes. That means sending it to a collections agency sooner or even suing you. And when a creditor takes legal action, the debt-settlement companies drop the account: They don't have the right to give legal advice or represent you in court.

High drop-out rates

While there's no independent research on the average success rate of debt-settlement programs, anecdotal evidence shows many consumers drop out before the company reaches a settlement with their creditors, Linfield says. "As you talk to bankruptcy attorneys you'll hear horror stories of clients who paid thousands of dollars to a company and they're still in the exact same place," she says.

Consider what happened at National Consumer Council, which was shut down by the Federal Trade Commission in 2004 on accusations of falsely claiming nonprofit status. The company's court records show that only 1.4% of the consumers who signed up for the program ever completed it. Nearly half — 42.9% — dropped out, paying an average of $1,780 in fees and saving $966 in their escrow accounts.

What debt-settlement companies won't tell you

1. Debt settlement may not be right for you

Debt settlement is a niche solution that's right only for a small segment of the population, says Charles Phelan, founder of ZipDebt.com, who coaches consumers on do-it-yourself debt settlement. But don't expect to hear that from a debt-settlement company. "People working the desks at the debt-settlement companies are working on commission and have the incentive of bringing as many people as possible," he says.

You could be a good candidate for debt settlement if you're heading toward bankruptcy, but don't qualify for filing Chapter 7, Phelan explains. (Under Chapter 7, most of your unsecured debts are written off, but you'll most likely have to sell some property including your home). "Most people who can qualify for Chapter 7 in all likelihood lack the cash flow to make debt settlement work for them," he says. Debt settlement, in other words, might be a viable alternative to Chapter 13, which sets up a three- to five-year schedule with your creditors to repay your debts.

Likewise, if you can scrape up the cash to pay off your debts in a debt-management program, where you work with a debt-management company to pay off your balances in full but with lower interest rates, then debt settlement isn't the best solution.

2. Your credit will suffer
Creditors don't settle unless you're severely behind on your payments. That means one thing: Debt settlement is damaging to your credit. Just how damaging it is depends on your track record. If you're already behind on payments, your credit will suffer less than if you've managed to avoid delinquencies and credit charge-offs.

3. You could get sued
With bankruptcy, creditors have to stop collections efforts as soon as you file. That's not the case with debt settlement. Even if you inform your creditors of your efforts to settle, they won't stop trying to collect, Phelan says. Worst-case scenario, they could sue you for the amounts you owe. Should that occur the only way to avoid a black mark on your credit record would be to pay off the debt in full.

4. There are tax consequences
Debt settlement is a taxable event. Any forgiven balance that exceeds $600 is taxable income, says Linfield. "Sometimes that tax event can put people in worse shape than they were in to begin with," she says. Consider this: If your tax rate is 15%, $5,000 of forgiven debt will carry a $750 tax liability. That's a debt that the IRS won't forgive. One exception: If you're insolvent — namely your assets are less than your liabilities — you can petition the IRS to waive that tax liability by filing form 982.

5. Our services might be illegal
While the laws regulating debt-settlement companies vary greatly by state, it's worth noting that 12 states currently prohibit for-profit debt management. Since debt-settlement companies are for-profit entities, they're not allowed to practice there. Those states are Arizona, Georgia, Hawaii, Louisiana, Maine, Mississippi, New Jersey, New Mexico, New York, North Dakota, West Virginia and Wyoming. If you live in one of those states, remember: It is illegal for for-profit debt-settlement companies to contact you and work with you, even if they're based in another state. "Many companies do it anyway," Linfield says. "And that's a big red flag."