Consumer Guide to Debt Settlement

Can You Really Get Out of Debt Paying Less Than You Owe?

Debt settlement companies advertise that they can help you pay off your debts for "pennies on the dollar," but some of these companies have drawn intense criticism by regulators and consumer advocates for failing to help consumers, and charging high fees that drive consumers deeper into debt. In this consumer guide, we will help you understand what debt negotiation is, help you understand whether it can help you get out of debt, as well as warn you about potential pitfalls and consumer protection rules these firms must follow.

What Is Debt Settlement?

Debt settlement (also called "debt negotiation" and sometimes mistakenly referred to as "debt consolidation") is an approach to getting out of debt. If you can’t pay the full amount you owe, a settlement firm will try to help you negotiate deals with your creditors to pay off your balances for less than you owe.

We’ll use the story of "Greg" as an example throughout this piece. Greg is a self-employed photographer. He owes $35,000 on four credit cards. His income has decreased by 25% over the past year, but his credit card interest rates and payments increased. He has fallen behind on his minimum payments, and can’t see a light at the end of the tunnel.

Am I A Good Candidate for Debt Negotiation?

That depends. Before you consider debt settlement, find out if you can pay back your debts through a credit counseling organization's Debt Management Program (DMP). With a DMP, you make one monthly payment to the counseling agency and they pay all your participating creditors. Interest rates and fees are usually reduced to make your payments more affordable. However, with a DMP, you must pay back 100% of your debt, plus interest. If that’s impossible, you can consider settlement.

Greg sets up a free initial consultation with a credit counseling agency. To pay off his debt with a DMP, he would have to make fixed monthly payments for five years. Given the fact that his income has been reduced, and the fact that it varies from month to month, he does not believe he can stick with the payment plan they propose. He decides to look at other options.

Settlement Versus Bankruptcy

Bankruptcy allows you to either eliminate most or all unsecured debts quickly (in a Chapter 7 plan) or pay back a portion of your debts over five years (in a Chapter 13 plan). It offers the legal protection of the court, so you don’t have to worry about being sued or harassed about your debts while you are completing your bankruptcy. Debt settlement does not give you the legal protection bankruptcy does.

Chapter 7 bankruptcy is not an option for everyone; it has become more difficult for some debtors to qualify. Chapter 13 bankruptcy requires five years of court-ordered payments, and may force you to surrender some assets. But there is no harm in talking with a bankruptcy attorney to learn about whether it might be the right move for you. Visit Nacba.org or ABI-world.org to find a local consumer bankruptcy attorney.

Greg meets with a bankruptcy attorney and learns he would likely be a good candidate for a Chapter 7 bankruptcy, allowing him to discharge (wipe out) his credit card debt. However, he feels a strong obligation to pay back as much of his debt as he can. He decides to try to find another option, but knows that he can always consider bankruptcy as a last resort.

Can I Just Settle My Debts By Myself?

If you have one or two debts, or owe a small amount, you may want to try to negotiate with your creditors yourself. But if you owe a lot of money to one creditor, or have several debts you need to settle, you may want to get professional advice.

That’s because debt settlement is as much an art as a science. It’s hard for the average person to know whether the settlement offers creditors are proposing are "good.” And it can be tough to handle the stress of creditors and collectors clamoring for payment all at once. It’s easy to make poor decisions under that kind of pressure.

Greg has tried to talk with his creditors about lowering his interest rates and monthly payments. One creditor was willing to offer him a low interest rate for a year, but then the account would revert to a high interest rate. Another refused to negotiate and threatened to turn him over for "legal action” if he didn’t catch up on his payments.

How Will Debt Negotiation Affect My Credit?

The bottom line is, you can’t settle debts when you are current on your payments. Debt negotiation is available to consumers in hardship situations, not those who have the ability to pay their minimum payments. That means you will have to stop paying your unsecured debts if you want to settle.

In addition, it is usually impossible to settle some debts but pay others on time. Creditors and collectors can review your credit reports, and they will not want to see they are getting paid less than the full balance when you are paying others on time. (This does not apply to secured debts such as car loans or a mortgage, both of which you must pay on time to avoid the risk of repossession or foreclosure.)

That means your credit report will be very negatively affected by settlement. Once your debt is settled, you will begin rebuilding your credit.

For the first time in twenty years, Greg has been unable to pay his bills on time. He feels terrible that his credit rating will be damaged after years of on-time payments, but he’s accepted the fact that he won’t be able to get through this unscathed.

What About Taxes?

Forgiven debt is considered taxable income. This means if you owe $10,000 and settle for $6,000, the $4,000 difference is taxable income. The creditor is required to send you a 1099 reporting this "discharge of indebtedness income.”  However, you may qualify to have the tax waived on forgiven debt if you can show that you were insolvent at the time you settled. Talk to an accountant or another financial professional to get more information.

Tip: It’s very important to get advice from a tax professional at the time you settle a debt. Don’t wait until April 15th, when you are filing your taxes, to try to find out whether you qualify.

Greg talks with a tax advisor and finds out that, based on his financial situation, he would likely be able to get the tax waived on part or all of any debt that is forgiven. He feels better knowing that if he can successfully negotiate settlements, he won’t have to face a bill from the IRS.

Where Can I Find A Good Debt Relief Company?

Be careful. Debt relief firms have generated thousands of complaints to state and federal regulators. In addition to debt settlement scams, be on the lookout for companies offering "debt elimination” and other fraudulent programs. See our list of fourteen questions to ask a debt settlement company.

A good company will help you understand what your options are but will also be very realistic with you about the challenges you might face as they work to help you clear your debt. Often, the bad companies simply want to scam you by collecting a fee from you up front, but they won’t help you resolve your debt.

Greg finds a debt settlement company that clearly explains the pros and the cons of this approach. He decides to get their help to negotiate. He stops paying his monthly credit card payments, and puts that money into a savings account. His aunt gives him a small interest-free loan and he sells some of his photography equipment so he can build up his settlement fund faster. Within fourteen months he has been able to settle all but one of his credit cards for an average of fifty cents on the dollar. The last creditor threatens to sue him, but eventually agrees to settle as well. Eighteen months after he started the debt negotiation program, he is debt-free. His financial problems are not over, but he is better able to focus on generating income because he is not constantly dodging creditor calls and letters.