D-E-B-T has become a new four-letter word for many Americans who are struggling to pay off massive amounts of consumer debt in the form of credit cards, car loans and other types of consumer credit. The amount of aggregate consumer debt in the U.S. now tops $11 trillion (yes, trillion with a “t”), according to the Federal Reserve Bank of New York.
In their search for a quick fix to their debt dilemma, many people turn to debt settlement companies who promise to help them get out of debt fast. But are these companies legit? And if so, should you hire one to help you solve your debt problems?
Legit vs. Shady
The answer to the first question is, “it depends.” While there are many legitimate debt settlement companies that are operating legally and following the laws that govern the debt settlement industry, there are also plenty of shady credit repair outfits that are little more than well-disguised rip-offs and scams.
According to the Federal Trade Commission, one thing to watch out for is a debt settlement company that “promises” or “guarantees” to settle all of your debts for a fraction of the total amount of money you owe (like “pennies on the dollar”). A legitimate company will not make such promises or guarantees, notes the FTC. Another is a company that tries to charge you an upfront fee for its services. Debt-relief companies are prohibited by law from collecting any money before they have settled a debt.
In addition, they can only charge you a percentage of their full fee for each debt they settle. For example, if you owe money to four creditors and the company negotiates a debt settlement with one of them, it can only charge you a portion of its total fee. It can then charge another portion if it negotiates a settlement with another creditor, and so on.
Another red flag the FTC says to watch out for is any debt settlement company that touts a “new government program” that will bail you out of your credit card debt. Also, be wary of companies that claim they can stop calls from debt collectors, or stop creditors from filing lawsuits against you, the FTC urges. (In order to halt such calls or suits legally, a formal bankruptcy filing must first be made.)
How Debt Settlement Works
Assuming you have found a debt settlement company that appears to be legitimate, should you retain them to help you reduce and /or restructure your debt? Before doing so, it is important to understand how the debt settlement process works with these companies.
Most debt relief companies ask their clients to stop making payments on their debts to their creditors and instead send the money to them. They will hold the money in an escrow-like account to pay off the settlements they are going to try to negotiate with creditors. The companies will then offer creditors a lump-sum payment that is less than the full amount owed. Sometimes, creditors are willing to accept such offers because it saves them the time and expense of trying to collect the debt, and it ensures that they will at least get something from past-due debtors.
But the key word here is sometimes. There is no guarantee that your creditors will negotiate a settlement with the debt relief company. If they don’t, and you have stopped making payments to them, you will likely be facing late fees and penalties, accumulated interest and other charges that have increased your debt perhaps exponentially. In addition, the creditors may then pursue legal action against you to collect the debts.
In fact, a recent study conducted by the Center for Responsible Lending found that when debtors stop paying creditors as part of a debt settlement program, their balances increase by an average of about 20 percent. Not paying creditors can also damage your credit score, the Center noted, and subject you to calls from creditors trying to collect your debts. “Although debt settlement may first appear attractive, harms stemming from defaulting on debt may leave consumers worse off,” the report concluded.
Another factor to consider is that debt relief programs are rarely quick fixes. They often require debtors to deposit money with them for up to three or four years until enough money has accumulated to pay off negotiated settlements. It is not uncommon for debtors to be unable to make deposits for this long and drop out of the program before they have saved enough money to pay off a debt settlement.
Finally, keep in mind that if you are offered a debt settlement by a creditor, you might have to pay taxes on the amount of debt that is forgiven. Depending on your financial situation, forgiven debt could be considered to be income by the IRS and subject to taxation at ordinary income tax rates.
Look for These Disclosures
According to the FTC, debt relief companies are required to provide you with certain disclosures before you sign up with them. These include:
- The price and terms of their services, including an explanation of their fees and any conditions on their services.
- How long it will take to get debt relief results — specifically, how many months or years before they will make a settlement offer to each of your creditors.
- How much money, or what percentage of each outstanding debt, you must save before it will make a settlement offer to your creditors.
- The possible negative consequences if you stop making payments to your creditors, as noted above.
- The fact that deposited funds belong to you, not to the debt settlement company, and you are entitled to the interest earned, as well as the fact that you can withdraw your money any time without penalty.
- The fact that the account administrator is not affiliated with the debt settlement company and does not receive any referral fees.
Other Debt Options
The FTC stresses that there are other, often better, options for getting out of debt than working with a debt settlement company. For example, you can negotiate directly with creditors to reduce or restructure your debt, instead of paying a debt relief company to negotiate for you. "If you're looking to settle previous debts, it's best that you deal directly with either the creditor themselves or the collection agency that now owns that debt," says Greg McBride, Chief Financial Analyst at Bankrate.com. "You want to deal directly with them because they have the ability to report to the Credit Bureau that it has been fully satisfied once you settle it."
You can also work with a credit counseling organization that can offer advice on reducing debt and improving personal money management. Note that although the first counseling session is free, there might be a fee involved in joining a debt management program with such an organization, even if it is a non-profit.
With some legwork and personal financial discipline, you can probably accomplish the same thing that a debt settlement company would do for you on your own. "Some little things that people can do that would have a major impact on reducing their debt is focusing every quarter, or every six months, on re-quoting some of the services that they have in place right now — their cell phone, their insurance bill," advises Adam Carroll, the Chief Education Officer at National Financial Educators. "I recently requoted my homeowners insurance and my car insurance, and I saved $1500 using one phone call." Then you can put the money you would have paid them to better use — like paying down your debts.
If you want to settle outstanding debts for less than what you owe, try our debt settlement tool.