What Debt Settlement Companies Don’t Want You to Know

In the early 2000s, this country witnessed an explosion in the growth of the debt settlement industry, along with a growth in complaints against it. Promising ultra-low pay-offs and preying on consumers’ fears, their distaste for big credit card companies, and even their political partisanship, debt settlement companies rarely discuss or make clear the high probability of several very negative consequences of their work with debtors.

What Do Debt Settlement Companies Not Tell You in Their Advertisements?

Advertisements for debt settlement, often running late at night on TV or radio and starting with the statement, “If you have $10,000 or more of credit card debt,” give consumers the hope that they can get out of half their debts with no penalties. Some commercials may even blatantly make the false claim that the current US president recently signed certain legislation giving consumers permission to stop paying their credit card debts.

Such advertisements do not mention the high likelihood of the consumer being sued and having his or her wages garnished long before any settlement can take place. They do not mention the major negative results on the consumer’s credit report caused by settlement activities. They do not mention their high fees.

Regardless of successful cases, a debt settlement company will highlight during their commercial, even if they are listed as an attorney’s office*, there are many drawbacks to debt settlement activities you should be aware of before you sign any agreement with these organizations.

The Nine Realities a Sketchy Debt Settlement Company Will Not Tell You

1. You Can Settle on Your Own, Without Paying a Company on Your Behalf

Debt negotiators want you to believe that their name or the fact that they are an attorney guarantees greater success in the debt settlement process. However, you can achieve equal, if not better, results on your own, without ever having to hire a third party.

Debt settlement companies count on consumers being uncomfortable with conflict and negotiations to build their clientele. However, if you are confident and persistent in what you want to achieve, you can often achieve the same 50% results as professional negotiators without having to pay their fees.

The main barrier here is not your ability to negotiate but the fact that you likely have no money to offer as leverage. This is the exact same scenario settlement companies face, which is why they ask you to send a “no contact” letter to your creditors while simultaneously requiring you to deposit money every month in a settlement fund they control. Until there is a significant amount of money in that account, the negotiator can do nothing on your behalf that you couldn’t already do yourself.

2. You Are Highly Likely to Be Sued Before Ever Settling Your Debt

This is probably the single most important truth to know about proceeding with debt settlement.

Being sued by a creditor is no light matter and places you in a position with no easy or pleasant options. If you were to put yourself in your creditor’s shoes, what would be your reaction if you received a “no contact” letter from someone who owes you money? You would be none too happy. You might even consider using a few choice words. Creditors might be big or small businesses, but they are run and managed by people who also have emotional reactions.

Upon receipt of a “no contact” letter, creditors will internally answer a series of questions about your account to decide how to react. If the balance owed on your account is large enough to justify court and legal costs, they will consider suing you so they can proceed to garnish your wages. Additionally, with a money judgment in most states, the creditor can levy (take) cash from your bank account or place a lien against real estate you own and maybe even on personal property (vehicle, collections, etc.). With an assignment order from the court, the creditor may also intercept and take your anticipated tax refund.

If you are sued and your creditor has a judgment against you, your options have just become very limited. The only ways out of a judgment typically include:

• satisfying (paying) the judgment in full

• being in such a poor financial situation that the creditor considers you “judgment proof” (you have minimal income or only state benefits income, no property or assets, and you have no money in a bank account)

• filing for bankruptcy

Given the enormity of the potential consequences, you can understand why debt settlement companies are hesitant to discuss what might happen if you are sued. Unfortunately, as we have seen when many debt settlement customers seek our assistance after having gone down the debt settlement route, lawsuits are far too common to ignore when considering whether to negotiate your debts.

3. Your Credit Will Be Affected for Seven Years

When you negotiate with a creditor to accept less than what is owed, the creditor will generally report your account as settled for less than the full balance. This mark typically remains on your credit report for seven years from the date of settlement, unless you already had late payments on your account that were never brought current. Delinquent accounts can hurt your credit rating more than any other action on your report, excluding bankruptcy, foreclosure, and accounts closed for non-payment.

A settlement reported to your credit can lead to a drop of as much as 10% in your score, depending upon your current rating and past credit behavior.

4. You May Have to Pay Taxes on Any Amount Settled on Your Account

If you settle an account for less than what you owe, the IRS essentially considers that you have already spent money that you are now not going to repay (e.g. owning money on a credit card). In their eyes, this is the equivalent of income, and you will likely have to pay income tax on it. In fact, the creditor will send you a 1099-C form at the end of the year if they have forgiven $600 or more of debt. Even for smaller amounts, though, the IRS still notes that you are required to report it as “other income” on your tax return.

Let’s say you settled a $10,000 debt for just $6,000. The $4,000 of forgiven debt is now considered taxable income. If your household pays income tax in the 20% range, you will now owe the government another $800 with your tax return.

In some cases, households have low enough incomes that the forgiven amount will not change their taxes owed. Not surprisingly, settlement companies seize on these scenarios to downplay the likelihood of a consumer having to pay income tax after a successful settlement.

5. Adding the Negotiator Fees and Possible Taxes Due, You Will Pay 70% to 95% of Your Original Balance, Not 50%

The 50% advertised settlement amount is very effective in getting the attention of any consumers struggling with credit card debts. Unfortunately, the reality of how much the consumer ends up paying, even in the small percentage of successful cases, is much higher than 50%. Debt settlement companies usually charge between 15% and 25% fees on the amount they negotiate off the consumer’s balance.

As an example, on a $10,000 balance successfully negotiated to a 50% settlement with a 25% fee, you will pay a $1,250 settlement fee and may incur a tax liability of $1,000. In total, you would be $7,250 or 73% of your debt to settle for a 50% deal.

6. A Federal Rule Prohibits Settlement Companies from Charging you a Cent Until After They Arrange a Settlement on Your Behalf

A 2010 federal rule (the Federal Trade Commission’s Telemarketing Sales Rule, or TSR) prohibits debt settlement companies that acquire clients via telephone calls (incoming or outgoing) to charge their customers a fee until after they have reached an acceptable settlement between the creditors and the consumer. If a settlement company begins to charge you a fee before offering any settlement service, they may be in violation of this rule.

As a result of this rule, many settlement companies outsource their marketing activities as a way to get around it. By hiring third-party companies (often owned by the same company), they argued that they were not acquiring clients by incoming or outgoing phone calls but by referrals from other companies. In the fall of 2019, the Consumer Financial Protection Bureau engineered its own settlement with the country’s largest debt settlement company after charging it had violated the TSR.

As a savvy consumer, you should avoid working with any settlement company that requires you to pay fees before it provides you with satisfactory service. Otherwise, it is very possible you are contracting with a fraudulent organization that will disappear into thin air, along with your money, after just three or four months.

7. There Is No New Law Signed by Any President Giving You the Right to Not Pay Your Debts

A staple of late-night debt settlement company ads is their reference to some vague, obscure new law that the current president has signed that makes it legal for you to not repay your debts. Capitalizing on the highly charged political climate of our country, these ads can get consumers’ hopes up, even though there are no laws providing any such rights.

To be sure, you are already free to not pay your debts. However, such freedom does not guarantee you any freedom from consequences. The creditor will quite likely exercise their own rights to report negative information to your credit file, take you to court, garnish your wages, and otherwise make your financial future even more difficult than it may already be. The right to do something does not release you from the consequences of that choice. Unfortunately, unprincipled debt negotiators count on consumers not considering these consequences.

8. Your Debt Balances Will Balloon Over the Next Few Years

As mentioned above, the first thing a debt settlement company will ask you to do is send a “no contact” letter to your creditors to cease all contact with you. Debt settlement companies are highly unlikely to tell you that your creditors, while not contacting you according to the Fair Debt Collection Practices Act, will likely continue to add penalty fees and eventually legal fees to your balances. In many cases, balances on consumer accounts will increase by 50% or even 100% within just a year or two due to penalty fees, penalty interest rates, or legal fees associated with the creditors’ actions to take the consumer to court.

9. Many Debt Settlement Companies Will Push You to Take out a “Settlement Loan” within a Year to Settle Your Debts

Relatively recently, many debt settlement companies have begun to act less like an advocate for their clients and more like a funnel to high-risk, high-fee lending institutions. Many debt settlement companies now push their clients away from the “save-for-one-to-two-years-before-we-offer-a-settlement” model toward companies that will make a debt consolidation loan to the consumer at interest rates as high or, more often, higher than the APRs on their original debts. These short-term loans typically carry terms of three to five years. These loans can easily put the consumer back into the situation of being unable to afford their monthly payment, leading to even more financial troubles in the future.

*Many settlement services are offered through respected attorney offices. Many others simply use attorney names to lend legitimacy to their business.

Debt settlement, also known as debt negotiation, is the process by which a consumer or his/her representative offers the creditor less than the full balance owed in exchange for the creditor to agree to stop collection attempts. Debt settlement companies, whether for-profit or nonprofit, whether fronted by an attorney’s name and credentials or not, typically advertise their attempts to negotiate a payoff of just 50% of the original balance due. They may even tout successful cases where they have saved a client thousands of dollars in payments.

Debt settlement companies ask you to complete two basic tasks after signing up for their services: 1) mail letters to your creditors requesting they cease contacting you and 2) start making monthly payments to the settlement company to build up your settlement fund.

By law, a creditor can no longer contact you by phone, email, or mail once you send them such a request in writing (by mail). However, this does not prevent them from getting their own attorney involved and taking you to court for added leverage to get you to pay your debt.

As for your monthly payment to the settlement company, you are told that once the balance reaches about 50% of one of your creditors included in your debt settlement plan, the company will reach out to that creditor and use that money as bate to force the creditor to accept less than what is owed. Basically, the settlement company tells the creditor that if they do not accept half of the balance, they will be unlikely to receive anything due to the possibility of their client (you) filing for bankruptcy in the future.

In every case, it is left to the creditor’s discretion to accept or reject the offer. No creditor can be forced to accept less than what is owed. Instead, the creditor will consider additional possibilities, including taking you to court to win a judgment against you (which they almost always will if you owe the money) and then proceed to garnish your wages. State laws vary dramatically with regard to how much a creditor may garnish from your wage. The most common limitation is 25% of your disposable income (usually your gross pay minus the standard deducted payroll taxes and your health insurance premiums). Child support and other familial obligations typically have much higher limitations.

The debt settlement process is generally a rather combative process, pitting the creditor (who naturally wants to get back as much of the money they have already lent) against the consumer (who is trying to pay as little of their debt as possible).

Related Questions

What happens if a creditor sells your debt? When you have not made a payment for several months, a credit may decide to sell your account to a collection agency, often for 30% to 40% of the current account balance. The debt collection agency then attempts to contact you to request the immediate, full payment of the debt. Because the agency paid far less than the balance for the account, it is usually willing to accept a less-than-full-balance payment to settle the debt.

Will credit card companies settle your debt? Virtually all credit card companies will be willing to settle your account for less than what you owe if the situation appears dire enough for them. Basically, credit card companies would rather get 80%, 65%, or even 50% of their money back if the alternative is losing it all in bankruptcy court. However, some credit card companies will only work out settlements directly with their customers and not with a third-party negotiator or attorney.

What are the alternatives to a debt settlement company? Alternatives to using a debt settlement company include setting up a debt repayment plan directly with the creditor to repay over time, attempting to settle the debt on your own directly with the creditor, working with a nonprofit credit counseling agency to set up a credit card debt consolidation plan to repay the creditors in full over the next five years or less, and meeting with a bankruptcy attorney to discuss a Chapter 7 and a Chapter 13 bankruptcy filing.