In the debt settlement process your accounts remain in default. You can still be sued by creditors seeking to recover debts that are being “settled” under a debt settlement program. While the debts are still in default the creditor or its assignee can still file a lawsuit against you.
With bankruptcy, creditors have to stop collections efforts as soon as you file. That’s not the case with debt settlement. Even if you inform your creditors of your efforts to settle, they won’t stop trying to collect. Credit card accounts typically go into collection after they are charged off, typically 180 days after the last payment on the account. The debt settlement companies may not handle calls from the credit card companies, nor the collection agencies.
Worst-case scenario: Your creditors could sue you for the amounts you owe. Should that occur the only way to avoid a black mark on your credit record would be to pay off the debt in full.
According to a recent survey by InsideARM, a website serving the debt collection industry, only 5 percent of credit card issuers indicated that they work with debt settlement companies. (InsideARM Debt Settlement Survey – How Creditors and Collectors Utilize the Debt Settlement Industry to Increase Collections, October, 2011)
In order to work with a debt settlement company, you need a lump sum of cash (best scenario), or you need to build up enough funds over a pre-determined period of time. If you have no cash to make a lump sum settlement offer, debt settlement companies set up a third party “trust” account where funds accumulate for the settlement process. Once enough funds are built up the negotiation process can begin with each creditor individually.
Some companies charge a percentage of the total debt – typically 15% or 18% – that is paid before you start accumulating savings to settle your debts. Others charge a percentage of the debt savings – usually 25% – once you settle, plus an initial sign-up fee and monthly service charges. Then there are those that charge a flat monthly fee throughout the length of the program. It is not unusual to find debt settlement companies charging more than $5,000.00 in fees in order to “settle” $30,000.00 in debt. That is $5,000.00 in fees charged in order to avoid (at best) 50% of your debt while a typical bankruptcy attorney may be able to eliminate ALL of your debt for a total fee of $1,350.00 or less.
Your credit reports will show evidence of debt settlements and the associated FICO scores will be lowered temporarily as a result, the same as if the debts had been discharged in bankruptcy.
The specific debts of the borrowers themselves affect the success of negotiations. Tax debts and domestic judgments remain unaffected by attempts at settlement. Student loans, even those not federally subsidized, have been granted special powers by recent legislation to attach bank accounts even without a court judgment without possibility of Chapter 7 bankruptcy protection. Also, some individual creditors, like Discover Card, for example, tend to have an aggressive resistance against negotiations.
If your debts are partially canceled outside the bankruptcy system you will need to report the canceled portion of the debt as taxable income. (IRS Publication Form 982) The IRS considers $600.00 or more of forgiven debt as taxable income. The forgiving creditor must provide the you with a 1099-C tax form. This form will list the amount of forgiven debt and interest in Box 2. Consider: If your tax rate is 15%, $5,000 of forgiven debt will carry a $750 tax liability. That’s a debt that the Internal Revenue Service won’t forgive and can NOT be discharged in a subsequent bankruptcy case.
Debt settlement companies generally take a percentage of the savings of the forgiven debt as the fee for their services. The drop-out rate of debt settlement programs is high because these programs generally last between 12-60 months and consumers who find themselves in these sorts of debt situations tend to have trouble sticking to a structured payment program for an extended period of time.
While there’s no independent research on the average success rate of debt-settlement programs, anecdotal evidence shows many consumers drop out before the company reaches a settlement with their creditors. As you talk to bankruptcy attorneys you’ll hear horror stories of clients who paid thousands of dollars to a company and they’re still in the exact same place. Many times people will even cash out their 401(k) or IRA retirement savings to pay off or settle their debts. This retirement savings is money that you would have been allowed to keep, regardless of the amount of your retirement savings, if you had instead filed for bankruptcy protection.
Though the laws regulating debt settlement companies vary greatly by state, it’s worth noting that 12 states prohibit for-profit debt management. Since debt-settlement companies are for-profit entities, they’re not allowed to practice in those states. Those states are Arizona, Georgia, Hawaii, Louisiana, Maine, Mississippi, New Jersey, New Mexico, New York, North Dakota, West Virginia and Wyoming.