A few weeks ago, I wrote about the dangers of PayDay Lenders in an effort to raise consumer awareness. It seems like the longer the recession goes on, more and more consumer predatory industries are being regulated by individual states and the federal government. They are attempting to clean up the damage done by years of less regulation but are still leaving open loopholes for these industries to find ways to operate profitably. Case in point, the Debt Settlement Industry has blossomed over the last decade. According to the Association of Settlement Companies, an industry trade group, in 2015 there were 300 firms in the sector. Now, there are about 1,000 firms that handle $18 billion in consumer debt negotiations. The average consumer user has $30,000 in consumer debt.
So what exactly do debt settlement companies do?
A debt settlement company negotiates with banks and collection agencies to forgive part of the amount that you (as their client) owe to your creditors. Before they actually begin negotiations on your behalf, they require that you deposit monthly payments into an escrow account they also have access to. These monthly payments are first used to cover their commission fees for assisting you in your debt relief. Once their upfront fees have been paid, they commence actually contacting your creditors to negotiate an actual settlement amount. As you continue to pay into the escrow account, they use the funds to begin paying off your settled debt.
Sounds like a great idea and extremely helpful, so what are the drawbacks?
What are the drawbacks? There are too many to mention. For starters, the most ambitious statistics available show that customers only complete their debt settlement program 34% of the time! When customers don’t complete the program, they simply lose out on any upfront fees they have already paid and they don’t even make any progress towards satisfying their debts to creditors. Also, debt settlement companies tend to charge between 20 – 70% of the amount they actually help you save through settlement. Sometimes this is in addition to a flat upfront fee and a monthly recurring fee as well. There have been massive complaints to the FTC regarding the industry’s practices. Some complaints included companies stealing the entire escrow deposit amounts and never even contacting a single creditor on a customer’s behalf. According to MSN Money, there are five drawbacks everyone should consider:
Debt settlement is not for everyone- You could be a good fit if you are heading towards bankruptcy but don’t qualify for chapter 7. It may be a viable option instead of filing for chapter 13. Or if you can gather up enough cash to pay your debts in a debt management program then using a debt settlement company is not for you.
Your credit will suffer- Creditors don’t settle unless you are severely behind on your payments. Delinquent payments may still be hitting your credit report while you are paying the debt settlement company through an escrow account. It could take up to two years before the company even contacts your creditors.
You could get sued- Creditors aren’t required to stop collection efforts once you inform them of your efforts to settle. They could sue you for the amounts you owe even though you are attempting to settle through a debt relief settlement.
There are tax consequences- Debt settlement is a taxable event. Any forgiven balance that exceeds $600 is taxable income. So for example, if you are in the 15% tax bracket with a $5,000 forgiven debt, that carries a tax liability of $750. Under federal law, this debt won’t be forgiven without special lobbying and filing form 982.
Their services might be illegal- Since federal law doesn’t restrict the use of debt settlement companies, individual states have been left to regulate the industry themselves. So far 12 states (Arizona, Georgia, Hawaii, Louisiana, Maine, Mississippi, New Jersey, New Mexico, New York, North Dakota, West Virginia and Wyoming) have restricted their ability to operate in their state. However, some companies do not follow the law and solicit customers in states in which they are not permitted. Even if they are based in another state, they can’t operate in states in which the practice is illegal.
So if I’m in debt up to my neck, what should I do?
First and foremost, please remember that I am not a financial advisor. I am not giving you advice that you should act on but only my personal opinion. With that said, I personally would contact my individual creditors directly and ask them what options were available to settle my debt. Once you are in arrears, most creditors are willing to work with you but you have to reach out to them for assistance. Creditors want to get paid at the end of the day, they would rather you avoid bankruptcy all together! If this does not work for you or is not an option, seek the help of a non-profit debt counseling agency who’s primary goal is to provide debt relief assistance and not turn a profit. A simple Google search should pop up several in your area. Finally, if all else fails and you decide you need the help of a debt settlement company, do your research before you agree to any terms and conditions. Ask probing questions, check with the FTC to see if any complaints have been filed against them, make sure you get an explanation for all fees beforehand and see if they are negotiable. Also, stay in frequent contact with your service contact and make sure you review the monthly statements for your escrow account often. Watch for unexplained fees or shortages in the balance. Again, these are just my personal opinions and not statements of fact.
Finally, the single biggest way to avoid the trap of debt settlement companies is to never get into high consumer debt in the first place.