The Dangers of Debt Settlement

Scissors cutting credit cards

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Debt settlement companies promise to reduce debt by negotiating with creditors, but the potentially negative effects this will have on your credit score aren't clearly explained. You have likely learned about debt settlement as an alternative to bankruptcy or as a way to resolve a growing debt. Persuasive advertisements might promise you an easy way out of debt, or a way to simplify your payments, but never mention the full cost to debtors.

According to a 2018 survey by Northwestern Mutual, a majority of Americans (53%) cited debt reduction as their top financial priority. If you're current on your accounts, or even just one or two months behind (and you want to maintain a healthy credit score) then debt settlement is not for you.

If you think that debt settlement may be a practical solution to your problems, get the full story before making your decision.

How Debt Settlement Works

The process starts when you call a debt settlement company and tell them about your situation.

  1. You provide them with the names of your creditors and the amount you owe. The debt settlement company then gives you an estimate for reducing your debt along with a new, lower monthly payment. As advised by the settlement company, you stop paying your creditors and instead send payments to the debt settler.
  2. The debt settlement company puts your monthly payments into a savings account. Once the account has grown to a certain amount (this can take months and sometimes up to a year), the debt settlement company calls your creditors and begins negotiating a settlement. The settlement is an amount lower than your full outstanding balance.
  3. If your creditors agree to a settlement amount, the settlement company pays the creditors and takes a fee for the work of negotiating the settlement. This could be a flat fee or a percentage of the debt (usually around 15%) that was canceled.

The Dangers of Debt Settlement

On the surface, debt settlement sounds great. You pay the debt settlement company who, in turn, pays your creditors. In the end, everyone gets paid and you're able to move on with your life. But remember the part where you stopped payments to your creditors while the settlement was being negotiated? That's the part that can come back to haunt you.

Creditors don't typically settle debts unless they're a few months past due. That means you have to stop paying your accounts and allow them to become past due. The whole process typically takes 26 to 48 months for the debt settlement company and the credit card company to come to terms. During this time, interest and late feeds will make the total grow. Your late payments get reported to the credit bureaus, your credit score drops, and you might begin receiving collection calls.

Regardless of the debt settlement action, those late payments remain on your credit history for up to seven years. Until you start accumulating positive credit activity, you'll have difficulty getting new credit cards and loans. You may even find your credit score interfering with getting a job or a good insurance rate.

The Fallout

If the debt settlement company successfully settles with your creditors, the delinquent information isn't erased from your credit report. Instead, your account is updated to something that shows you've settled, such as "Charged-Off Settled" or "Paid-Settled."

A settled status isn't nearly as good for your credit score as a "Paid in Full" account.

After debt settlement, it may take a few months or even a few years to rebuild your credit and get approved for unsecured credit, and you may still owe outstanding taxes on settled debts. The Internal Revenue Service (IRS) treats forgiven debts as income and expects you to pay income taxes on the forgiven amount.

Creditors are required to send you a Form 1099-C for reporting canceled debts and the IRS will expect you to include the debt on your tax return.

Alternative Solutions

As of 2019, Americans are in debt to the tune of $14.15 trillion, 26.8% higher than in 2013. Almost 4.7% of outstanding debt was in some stage of delinquency and of the $669 billion of debt that is delinquent, $444 billion is seriously delinquent, at least 90 days late.

If you're in debt, you're not alone and there are resources that can help you without taking more of your money in the process. As a part of your debt management strategy, consider enrolling in consumer credit counseling, which helps you enter into a debt management plan with your creditors. There's a possibility of reducing your monthly payments, and you'll still be able to pay your balance in full, which will reflect on your credit report. As long as you make your payments on time each month, this process will not hurt your credit score, and can provide you with new information and resources.

You can also work out your own payment plan with your creditors. If you've missed one or two payments, ask your creditors if they have a hardship program for customers who are having financial difficulty.

Specifically use the word "hardship" in your conversation; you may be able to get help in the form of a temporary (six months to a year) reduction in your monthly payment or credit card interest rate.