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- First Amendment Handbook
- Debt Settlement: Cheapest Way To Get Out Of Debt?
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Common Credit Claim Challenges Faced By Kansas Consumers – If you’re in debt and can’t pay your bills, is a debt settlement program the cheapest way to get rid of your debt? You can draw that conclusion from a recent report by the American Fair Credit Council (AFCC), an industry association of companies operating in the debt settlement industry.
Debt settlement, also called debt relief or settlement, is the process of settling your outstanding debt for much less than the amount you owe by promising the lender a substantial lump sum payment. Depending on the situation, debt settlement offers can range from 10% to 50% of what you owe. The creditor must then decide whether to accept.
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“Debt settlement can save consumers money by allowing them to settle their debts for less than the full balance,” notes Gerri Detweiler, co-author of the e-book
First Amendment Handbook
“It can be a way out of debt for some individuals who can’t afford to pay back the full amount they owe,” she adds.
Consumers can try to settle their debts themselves or hire a debt settlement company to do it for them. In the latter case, you will pay the company a fee calculated as a percentage of your registered debt. Enrolled debt is the amount of debt you have when you enter the program. By law, the company cannot collect this fee until it settles your debt. Fees are on average 20% to 25%.
Debt settlement can also involve tax costs. The Internal Revenue Service (IRS) generally considers forgiven debt to be taxable income. However, if you can prove to the IRS that you are insolvent, you will not have to pay tax on the discharged debt. The IRS will consider you insolvent if your total liabilities exceed your total assets.
According to AFCC data compiled by Freedom Debt Relief, one of the nation’s largest debt negotiators, debt settlement is by far the cheapest option compared to credit counseling or making minimum monthly payments, as the infographic below shows.
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However, whether debt settlement will be the cheapest option for you depends on the specifics of your situation.
Ironically, consumers who enter a debt settlement program because they can’t manage their debt burden—but who still make payments, even sporadic ones—have less bargaining power than defaulters. Therefore, the first step is often to stop paying completely.
“Credit scores can be damaged during the debt settlement process, especially in the beginning,” says Sean Fox, co-president of Freedom Debt Relief. “As the consumer begins to pay off the settled debt, credit scores will typically recover over time.”
Becoming delinquent and settling your debt for less than what you owe can have a serious impact on your credit score—likely to push it into the mid-500s, which is considered bad. The higher your score before you fall behind, the bigger the drop Late payments can stay on your credit report for up to seven years.
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Defaulting also means accruing late fees and interest, which add to your balance and will make it harder for you to pay off your debt if you can’t pay it off. Consumers can expect harassing debt collection phone calls after becoming delinquent. Creditors could also choose to sue consumers for debts over $5,000 – in other words, debts that are worth their effort – which can result in wage garnishment.
“The more money you have available for settlement, the sooner you can settle the debt. The longer your debt goes unpaid, the greater the risk of being sued,” says Detweiler.
There are no guarantees that after you have suffered these damages, the lender will agree to a settlement or settle the debt for as little as you hoped. For example, Chase will not work with debt settlement companies. They will only work directly with consumers or non-profit, licensed credit counseling agencies that help consumers. The Consumer Financial Protection Bureau (CFPB) warns that accrued penalties and fees on outstanding debts could negate any savings a debt settlement company makes for you, especially if you don’t settle all or most of your debts.
When the process works as intended, debt settlement can benefit everyone involved. Consumers become debt free and save money, debt settlement companies make money for providing valuable services, and creditors receive more than they would have received if the consumer had completely stopped paying or filed for Chapter 7 bankruptcy. Chapter 7 bankruptcy involves the liquidation of the debtor’s non-exempt assets and using the proceeds to repay creditors. Exempt assets vary by state, but often include household and personal property, a certain amount of home equity, retirement accounts and a vehicle.
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Compared to debt settlement, Detweiler says, “if the consumer qualifies for Chapter 7 bankruptcy, it may be a faster option. It’s a legal process that can stop collection calls and lawsuits. Debt settlement doesn’t offer those guarantees.”
Still, she adds, “there may be a number of reasons why Chapter 7 may not be a good option. The consumer may have to hand over property that they feel should be kept. Or maybe they don’t want their financial difficulties to be a matter of public record.”
Individuals may also have limited employment opportunities if they declare bankruptcy, as some employers check applicants’ credit history as part of the hiring process.
Another problem that many indebted consumers face is the inability to afford a bankruptcy attorney. And in some cases, the court may reject their application.
Debt Settlement: Cheapest Way To Get Out Of Debt?
“Many consumers cannot qualify for bankruptcy protection,” says Fox. “In contrast, debt settlement is available to any consumer who can demonstrate financial hardship, such as job loss, reduced hours, medical expenses, death in the family, divorce, etc., and is struggling to make progress paying off their debt.”
A Chapter 7 bankruptcy can be completed in three to six months, compared to the years it may take to settle the debt. This can be less stressful and can allow your credit to recover more quickly, although a bankruptcy will remain on your credit reports for up to 10 years.
Many debt settlement programs require you to deposit a certain amount of money into a specific savings account each month for 36 months or longer. Before you sign up for the program, make sure you can afford to pay those deposits throughout the duration of the debt settlement program.
Paying minimum monthly payments on high-interest debt is not a good option for consumers looking to save money. This can take years – even decades – depending on how much debt you have and what the interest rate is. Interest is usually charged every day on your entire balance, and with minimum payments you make little progress towards paying off your balance each month.
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Consistently making the minimum monthly payments and spending tons of interest could make you very profitable for your creditors. A good payment history is good for your credit score, but spending more than you have to on interest is a very expensive way to improve your credit score. A good credit score won’t pay for your pension; money in the bank will.
Furthermore, if the amount of available credit you’ve used is high relative to your line of credit, it will hurt your credit score and potentially negate the effect of your consistent, on-time payments.
Consumers who consistently make only the minimum monthly payment on high-interest credit card debt may end up paying more in interest than the original principal.
Credit counseling is a free or low-cost service provided by some nonprofit organizations and government agencies. It is interesting that these services are often partially financed by card companies. By enrolling in a debt management plan with a credit counseling agency, you can get a reduction in the interest rate on your balances and a waiver of penalty fees.
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These concessions may or may not be enough to help you pay off your debt significantly faster, and you may not be able to afford the new required monthly payments. In addition, you may not be eligible for an interest rate reduction, even if you are experiencing significant financial hardship.
However, since you won’t have to pay off your debt, your credit score may be less affected. Also, credit counseling can offer additional financial assistance that can help you avoid similar problems in the future, such as budgeting advice and financial counseling, as well as referrals to other low-cost services and assistance programs.
So how do you know which option to choose if you don’t want to file for bankruptcy? It’s usually better to seek credit counseling before considering signing up with a debt settlement company. Credit counselors can help you determine the best course of action. This may involve settling debts, but in a way that will benefit you. On the other hand, a debt settlement company may be more interested in your fees than the health of your credit.
Credit counseling and debt consolidation loans are suitable for consumers with more modest financial stress on the financial hardship spectrum. At the same time, debt settlement and bankruptcy can help those who are under more financial stress. It very much depends on the individual situation.
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The Federal Trade Commission website has helpful information on how to choose a credit counselor. The National Foundation for Credit Counseling is another
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