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The average American household had nearly $9,000 in credit card debt alone at the end of 2019 — and that was before the coronavirus pandemic wreaked havoc on finances, causing sudden instability even for those who previously had a handle on their debt.
If you’re feeling the pressure, it’s important to explore your options for debt management carefully. One of those options is to work with a debt-settlement company — but it’s a strategy that comes with significant risks and downsides, according to personal finance experts.
Here’s how debt settlement works, and why it could hurt your finances in the long run.
Debt-Settlement Plans: What Are They and What Can They Help With?
Generally speaking, debt-settlement plans involve negotiating with creditors to settle a debt for less than its current value. This lower amount might be paid as a lump sum or in a series of installments, which can be negotiated either directly with the creditor or through a third-party debt-settlement agency.
Michael Sullivan, personal financial consultant at financial education nonprofit Take Charge America, notes that while certain types of debt could be eligible for debt settlement, other types are excluded entirely. As a rule of thumb, only unsecured debt is a candidate for debt settlement. Sullivan offers the following list as a more specific guideline.
Types of debt that may be eligible for debt settlement:
- Credit cards
- Retail store and gas station cards
- Unsecured personal loans
- Mortgage short payoffs
- Car repossessions
- Medical debt
- Private student loans
- Cell phone and utility bills from closed accounts
- Rent payments from past residences
Types of debt that are not eligible for debt settlement:
- Current mortgages or rent payments
- Second or third mortgages
- Home equity lines of credit (HELOCs)
- Federal student loans, such as Sallie Mae
- Criminal fines
- Court-ordered child support and alimony
- Back taxes
- Gambling debts
- Cell phone and utility bills from open accounts
- Rent-to-own agreements
How Do I Get a Debt-Settlement Plan?
Consumers searching for information on debt settlement are often bombarded with advertisements from debt-settlement companies. However, it’s important to know that working with an agency isn’t your only option.
“A commonly misunderstood view is that you need a credit counseling or debt-settlement organization,” says Susan Brown, CEO of First Connecticut Credit Union, Inc. But this isn’t the case. While the process requires hard work and persistence, it’s entirely possible to pursue debt settlement yourself by contacting creditors directly. Several banks, credit unions, and nonprofits also offer debt counseling services designed to help you explore all your options.
Still, some consumers find value in the services that a debt-settlement company provides. “The real value of debt settlement is in the effectiveness of the negotiation,” says Sean Fox, president of Freedom Debt Relief, a national debt-resolution company. “The better the negotiation, the lower the settlement will be.” This is why, if you do choose to work with a debt-settlement agency, choosing wisely is key.
Debt-settlement companies will typically ask you to deposit a certain amount of money each month into a savings account that is eventually used to pay the negotiated settlement amount, often after a period of two or more years. In the meantime, the company will negotiate on your behalf to lower the total repayment amount. But this service isn’t free. Most debt-settlement companies make their money by charging a percentage of either the total initial debt or the amount they save you; many also ask for monthly account maintenance fees.
The Risks That Come With Debt-Settlement Plans
The main downside of debt-settlement plans is there’s no guaranteed outcome, even if you go through a debt-settlement agency. While you’re waiting for a resolution — which often takes several years — you’ll suffer the consequences of missing payments. During that time, your creditors can still contact you and even sue for nonpayment, warns Sullivan. Additionally, “allowing accounts to fall behind during debt-settlement negotiations causes credit scores to drop significantly,” he says. “Delinquencies can stay on your credit report for seven years.”
It’s entirely possible that you’ll accrue fees, interest, and delinquencies, only to find out that your creditors weren’t willing to settle. If this happens, you’ll have effectively taken two steps forward and three steps back, now saddled with even more debt than you started with.
Debt-settlement plans can work for some people, but there’s no guaranteed outcome and some significant risks. So you should exhaust all your other options first.
How Debt Settlement Plans Affect Your Credit and Taxes
One of the main criticisms of debt-settlement plans is the long-term effects they have on your finances. Debt settlements go on your credit report and stay there for seven years, which can lower your credit score by more than 100 points.
As Brown points out, having a settlement on your credit report will lead to additional hidden costs on top of the fees you’ve already paid to the debt-settlement company. “The settlement negatively impacts your credit score, which in turn increases interest rates on any future borrowing,” Brown says. In other words, you’ll keep paying for the settlement in the form of extra interest on any accounts opened during this seven-year period.
A debt settlement has tax implications, too. The IRS requires you to report the total amount of canceled debt on your tax return as income. This means you could end up having to pay taxes on the amount you saved.
Beware of Debt-Settlement Scams
Debt-settlement companies are strictly regulated, but not everyone plays by the rules. Debt-settlement scams are far more common than you might think. The Federal Trade Commission (FTC) warns of a few red flags that you should look out for, which include:
- Promising to settle your debt for a specific percentage of what you owe
- Charging any fees before your debts are settled
- Failing to disclose the risks associated with debt settlement
- Asking you to stop making payments to creditors without explaining the consequences
- Claiming to prevent calls and lawsuits from debt collectors
- Advertising a “new government program” that forgives debt
If a company engages in any of the above tactics, you should stop communication and report them to the FTC using this link.
How to Properly Vet a Debt-Settlement Company
There are ways you can verify the legitimacy of a debt-settlement company. The FTC recommends checking with your state’s attorney general and consumer protection office. These agencies will be able to tell you if a company has any complaints on file and whether they’re properly licensed according to local regulations.
Fox has additional recommendations to make sure you’re working with a reputable company. “Ask questions, and expect answers,” Fox says. “The staff at the debt settlement company should be able — and available — to answer any and all questions about debt settlement, your accounts, and their fees. If a company appears to offer vague answers, look for another company.”
Fox also cautions against so-called online reviews that are in fact paid advertisements. When looking at review sites, check the fine print on the page for keywords like “sponsored content” or “ad” that indicate the review might not be legitimate.
To put this to the test, we did an internet search for debt-settlement company CreditAssociates. The first result was a 4.5-star review that, while appearing legitimate at first, included a disclaimer that the review was sponsored by the company. It wasn’t until the second result that we found a link to the Better Business Bureau website, where we discovered that the company had a B+ rating and a 2-star average customer review.
Our advice: Stick to reputable review sources, such as the BBB, for unbiased information on debt-settlement companies.
What Are My Other Options?
While debt settlement is a viable option for those who are several months behind on payments, it’s not the only one. In some cases, credit counseling can be enough to get you back on track. Credit counseling services are available for free from many financial education nonprofits and involve one-on-one mentoring with a qualified counselor. Before moving forward with debt settlement, consider talking to a credit counselor to make sure you’ve exhausted all other options.
Some people may also find that filing for bankruptcy is a better option depending on their financial situation. But you need to meet certain qualifications to file for bankruptcy, such as a maximum monthly income. Bankruptcies also stay on your credit report for seven to 10 years, depending on the type. This option can be discussed with a credit counselor to see if it’s the right solution for you.