If you’re drowning in credit card debt, the idea of paying much less than you owe and getting debt collectors off your back may sound appealing.
Debt settlement can be negotiated either by the consumer or by a third party who works with a creditor on a consumer’s behalf. The idea is that creditors would rather get some of what you owe rather than nothing. So they may agree to take less — sometimes a lot less — and be done with it.
But while debt settlements benefit some consumers, settling can have some negative effects on your credit — and may not even work.
Debt settlement pros and cons
A get-out-of-debt free card? Or a trap? Debt settlements may be a little bit of both.
Here are some pros:
- You pay less than you owe. Consumers can start negotiating at 75 percent off the total amount. You likely won’t get that lofty debt discount, but at least 50 percent off is common, says Bruce McClary with ClearPoint Credit Counseling Solutions. McClary, who previously worked in debt collection, says the more you owe, the more amenable a creditor might be to knocking off a bigger percentage.
- You may get debt collectors off your back. Your settled debts shouldn’t be fair game for further legal action or debt collectors, so you should see an end to persistent phone calls. The trick here is to get everything in writing before and after agreeing to the terms. If another company buys up your bad debt, it may try to go after you even if you’ve settled with the original company. If you don’t have documentation to prove you settled it, you’re sunk, McClary says.
- Regulations on for-profit debt settlement companies have tightened. Under new Federal Trade Commission rules passed in 2010, debt settlement companies can no longer legally charge upfront fees or misrepresent the services they offer. Now they get paid only when they have successfully negotiated, settled or reduced at least one of the debts you owe and once there is a written settlement agreement between you and your creditor.
Now, here are some reasons you may want to think twice (or three times) before settling your debt.
- Debt settlement rarely works. The Government Accountability Office reports that, despite claims from debt settlement companies that 85 percent, even 100 percent, of settlement attempts are successful, the reality is that fewer than 10 percent get settled. Moreover, debt settlements won’t work for some types of debts. They are only for unsecured debts like credit card debts and signature loans — not for secured debts like mortgages or car loans.
- You still have a black mark on your credit report. Those who need to settle their debts have likely already done significant damage to their credit scores by not paying their bills. So the damage from settling a debt shouldn’t be much worse. But you will look worse to future lenders than someone who pays off a debt over the long term. If two people with past delinquent debts are applying for the same kind of loan and one paid the debt in full and the other settled for half the balance, the lender will prefer the former every time, McClary says.
- Debt settlement services will cost you. Third-party companies take a percentage of the debt that you owe — as much as 20 percent, says Andrew Pizor, staff attorney for the National Consumer Law Center. For a $20,000 debt, your fee could be $4,000.
“A for-profit debt settlement is really a bad idea,” Pizor says.
- You still have to pay taxes on what you didn’t pay creditors. Think of a settlement as a monetary gift from a creditor. Depending on how much debt you had settled, you could owe taxes on that amount.
“That can be a big shock,” Pizor says. “If you get behind to the IRS, their interest rates are horrific. They’re worse for debt collection than your credit card company, because they can take your tax refund, they can do all kinds of things.”
- You may dig yourself in deeper.There’s no guarantee that a creditor will accept your offer. Meanwhile, a settlement company will likely advise you to stop making payments to the credit card company so you can build up an account to pay the settlement in one chunk. But while you’re not paying the bills, you’re racking up fees and penalties. You may go through the whole process over weeks and months, only to have the creditor say, “No.”
“You’re not just back at square one, you’re in a worse situation because of the time that’s gone by,” McClary says.
- Your card company may not deal with third-party settlement companies. Many of the major credit card companies won’t work with them, Pizor says. They may want to deal only with you directly.
- Even with the crackdown, complaints persist with debt settlement companies. FTC rules have helped, but there are still some companies operating outside the regulations. Legal Helpers Debt Resolution of Chicago, for instance, agreed to refund $2.1 million to its Illinois customers under a settlement announced in July. Rather than providing legal help, the lawyers were a “front” to collect hefty fees from struggling consumers, Illinois Attorney General Lisa Madigan said.
A last resort
Given the considerable negatives, debt settlement should be the last thing a consumer tries, financial experts say. It’s not for those who are simply a few months behind on their debts.
In fact, you may be better off filing for bankruptcy. Even though bankruptcy stays on your credit report for 10 years and unpaid debt stays on for seven, some creditors will still be more willing to work with you after a bankruptcy — partially because they know you can’t file bankruptcy again for a certain number of years, Pizor says.
“You might not get great interest rates, but you can still get a credit card,” after bankruptcy, Pizor says.
Consult a bankruptcy attorney or nonprofit credit counselor to see if it is a better option than settling your debt, Pizor says.
Another way to avoid a debt settlement — contact your creditors directly and ask them to cut you a break on interest, minimum payments or late fees so you can afford to make payments. There’s a caveat here, Pizor says: If they agree to this, your credit card company will close your account and you can’t charge on it, but you have a better shot at being able to pay of the debt.
Also consider consulting a nonprofit credit counselor who can look at your financial status objectively and create a plan that will honor your commitment to pay off the entire debt but in a way that works with your budget.
If you still feel your debt is too great and you decide on debt settlement, check out any debt relief company you work with thoroughly. Start with the Better Business Bureau, and look up complaints on the attorney general’s website in your state.
“Consumers need to consider every single other alternative when going the route of debt settlement,” McClary says.