When a potential client comes in for an initial consultation, one of the available options for a client with a debt problem is debt settlement. But is it a good alternative to bankruptcy? The answer is mainly no, it’s not, the reasons of which are spelled out below.
Debt settlement companies aren’t as loosely regulated as they once were, but can still operate outside the laws of Minnesota. Meaning many of them operate in other states while still doing business with Minnesota residents, charging fees that violate our state laws, and making them harder to police when they promise something they can’t deliver.
Debt settlement companies negotiate on your behalf with one or many creditors to forgive part of the debt in exchange for a lump sum payment. In exchange for this negotiation, you will pay the debt settlement company an upfront fee or a percentage of what was forgiven.
What to be aware of:
1. Timeline
Debt settlement is not quick. The average debt settlement takes between 3-4 years. It is not a matter of months and things will have been worked out. It is a slow process, even if you only have one credit account to settle.
2. Your credit score will plummet while this negotiation is taking place
This is because while in debt settlement you will stop payment on all your accounts, and instead start making payment into a “savings account” at the debt settlement company. Your credit report is going to reflect these missed payments. Your credit accounts will also need to have already been placed in collections or with a law firm before the debt can get settled for less than what is owed.
3. You will have to pay taxes on anything that is forgiven. This can be a HUGE surprise.
If you owe $10,000 to Discover and a debt settlement company settles on your behalf for $3,000, you will most likely get a 1099-C tax form: Cancellation of Debt, for $7,000, the amount that was forgiven. This $7,000 is now taxable income. Instead of getting relief in the amount of $7,000 you could now end up owing the IRS or MN Revenue at tax time.
4. Fees
A typical debt settlement fee is 20% of the settled amount. When you combine this 20% with the amount of fees and penalties that have been assessed (because remember this is not a quick process, and monthly fees and penalties will continue to be assessed) you may end up paying close to what the full balance of the debt was in the first place. A study of debt settlement companies found that it was not uncommon for people to pay 90% of the original balance owed in the end. Which is a far cry from how these companies advertise savings of up to 75% on settled
5. Debt settlement does not stop lawsuits
Just because you have hired a debt settlement company does not mean that a creditor won’t continue to move forward on getting a judgment against you and starting a garnishment. I have had many clients come to me after trying debt settlement and in the middle of the negotiation process, the creditors decided to pursue the lawsuit anyway. There is no law that says because you are in debt settlement, a creditor can’t decide to pursue other means of collection.
When does debt settlement make sense?
It most likely only makes sense when there is a large asset that can’t be protected in
Almost always bankruptcy is a better solution to a debt problem than debt settlement. A chapter 7 bankruptcy is a quick process, 3 months on average. You can begin rebuilding your credit on the day you receive your discharge, just 3 months after filing. Bankruptcy hurts your credit score no more than debt settlement. Most clients get to protect all their belonging under the bankruptcy laws, meaning no assets are turned over to the court. Whatever debt was erased in the bankruptcy is tax-free. You don’t pay taxes on anything discharged in the bankruptcy.
Another piece of information to remember is that bankruptcy attorneys have to have their client’s best interest in mind when giving advice on a debt problem. This is why at a consultation we will go through the options you have to solve your debt problem. A debt settlement company doesn’t have to have its client’s best interest in mind. Most likely all communications will be by phone and the people you speak to will be in sales, getting a percentage of commission just to get you to sign up with their company.
