Is Debt Settlement Worth It?

Debt settlement promises to cut what you owe. For some people it works; for many, it leaves them with damaged credit, lawsuits and fees.

How debt settlement works

1. You enroll unsecured debts, mostly credit cards.
2. You stop paying creditors and deposit money monthly into a dedicated account.
3. After months, the company negotiates with creditors to accept lump sums less than the balance.
4. The company takes a fee when each debt is settled.

The rules on fees

Under the FTC's Telemarketing Sales Rule, for-profit debt relief companies that sell by phone cannot collect fees until they have settled at least one debt, the customer has agreed to the settlement, and the customer has made a payment to the creditor (16 CFR 310.4(a)(5)). Fees are commonly a percentage of the enrolled or settled debt.

Risks

• Credit damage: missed payments and charge-offs lower scores significantly.
• Lawsuits: creditors may sue before a settlement is reached; settlement companies cannot stop that. See if a debt collector sues you.
• Growing balances: late fees and interest add up while you save.
• Not all creditors settle.
• Taxes: forgiven debt of $600 or more may be reported on Form 1099-C and can be taxable income, unless an exclusion such as insolvency or bankruptcy applies (26 U.S.C. 108).
• Dropping out: many people do not finish the program.

When it might make sense

• A lump sum is available or will be soon
• Few creditors, mostly credit cards
• Bankruptcy is not an option or not desired
• You can handle the credit damage

Alternatives

• Negotiating yourself with creditors or collectors, free of fees
• Nonprofit credit counseling and debt management plans, which reduce interest rates without settling for less (FTC)
• Hardship programs from card issuers
• Chapter 7 or Chapter 13 bankruptcy, which stops lawsuits and can discharge debts entirely; see Chapter 7

Red flags

Guarantees to eliminate debt, upfront fees, pressure to stop communicating with creditors entirely, or claims of new government programs.

A consultation with a bankruptcy lawyer can show whether bankruptcy would cost less than settlement.

Sources

1. Federal Trade Commission: How to get out of debt
2. Cornell Law School LII: 16 CFR 310.4(a)(5), Advance fee ban for debt relief services
3. Cornell Law School LII: 26 U.S.C. 108, Income from discharge of indebtedness