Debt Settlement Sets a Costly Trap
David Tenenbaum and Cassie Holman
/ September 30th, 2009
The debt-settlement industry is growing, but it can be a trap for the unwary. As millions of Americans struggle to pay down debt, many are lured in by debt settlement companies' promises to slash debt in half—or more.
The basic pitch goes something like this: "You pay an upfront fee (typically 15% of the pre-settlement balances) and we tell your creditors to talk with us and not contact you. Then you send us a monthly payment, which we'll store until you are ready to settle. When you are ready, we will negotiate a settlement with your creditors—many are willing to settle for 50 cents on the dollar. You'll wind up debt-free, with a solid credit rating."
Too good to be true
Attractive as the promises may seem, there are catches:
The Better Business Bureau (BBB) says to watch out for these red flags:
- Creditors don't see any payments until you decide to settle, so they may get increasingly frantic. That raises the possibility of more late fees and higher interest rates. The creditor even may send the debt to a collection agency. But you won't know about that because the communications will be going to the debt-settlement firm, not to you, says Kenneth King, executive director of Consumer Credit Counseling in Sheboygan, Wis.
- Some creditors may start a lawsuit due to nonpayment, especially if the debt is large. Debt settlement companies do not protect against legal action.
- Few creditors are willing to settle for such chump change.
- If they are, you can negotiate this settlement yourself, without paying the settlement company.
- If the debt does get settled at a discount, your credit rating will reflect your partial payment—and,
- You will owe income taxes on the discount.
- Hefty upfront fees
- Unrealistic promises to erase debt
- Orders to stop contact with creditors, and false claims that the organization is a nonprofit (you can verify a company's claims with the BBB). The BBB recommends getting advice from friends, family members, and people in your community to be sure a company is legitimate.
Many credit unions have credit counselors on staff or can refer you to someone who can help.
Debt settlement has earned its poor reputation, says Ken King. "They take advantage of people. In most cases, the consumer is misled into believing [he or she is] going to be able to reduce the debt without affecting their credit." But despite the "large up-front fee, and monthly maintenance fee, the consumer seldom receives any benefits."
Few clients who enroll in debt-settlement plans have sufficient means to complete them. They often drop out after paying service fees, and their financial situation is no better than when they began—and often worse.
Companies under scrutiny
Debt settlement companies have recently been under much scrutiny and making headlines. In early May 2009, in response to consumer complaints, New York Attorney General Andrew Cuomo launched a nationwide investigation of 14 debt-settlement companies. Later in the month, he filed suit against two companies on grounds of fraudulent business practices and false advertising. One of the companies promised a 60% reduction in its clients' debt, but only 1% of customers realized those results.
It's probably not surprising that debt settlement is seemingly so attractive. Many consumers are buried in debt, and debt-settlement companies' offers can seem irresistible. Although the economic crisis has caused the U.S. personal savings rate to recently increase, Americans had been on a credit-spending spree for years—with a negative savings rate in 2005 and only minimal increases until early 2008, when the economy really started to tank.
With debt settlement, "All the responsibility lies on the consumer," Ken King says. "The company gets the fee, takes the money, and I'm supposed to call them when it's time to settle, and have accumulated enough money to settle." But after paying the fee, he says, "I may not have anything left to settle with."
Although some consumers think they can absolve all debt by filing for bankruptcy, the federal bankruptcy law encourages alternatives like credit counseling and debt management, says Kathleen King (unrelated to Ken King), a former loss prevention manager at Citizens Credit Union in Kalamazoo, Mich.
Few clients who enroll in debt-settlement plans have sufficient means to complete them.
Before unsecured debt, typically from credit cards, starts to get out of control, Kathleen King suggests starting credit counseling, or talking to a reputable debt-management service. The name sounds like debt settlement, but she says the service is different. Both firms negotiate with creditors, but debt-management firms avoid those "something-for-nothing" promises. A debt management firm will ask creditors to "re-age" the account and make it current, which removes the late fees and returns the interest rate to normal. That way, payments go toward principal, not fees and interest.
She argues that the main selling point of debt settlement—the sterling credit rating—is an illusion. "In most cases, people have hired a company, and it has presented itself as having the ability to clear the credit, but it does not do that. The credit agency is not required to record the debt as 'paid in full,' just as 'settled for less than full balance.' "
Warnings about the Web
Kathleen King also cautions about searching on the Internet for a debt management firm. "We recommend a debt-management company in town; all the credit unions in town are working with this company; they do such a wonderful service." The people at your credit union can recommend a debt-management agency if you need one; some credit unions even offer credit counseling and debt-management service.
Furthermore, any effort to deal with debt must be comprehensive, she says. Unless you pay all the creditors, your credit rating still will be stained. "We want to address the entire situation ... it should not be a matter of paying the one that's screaming the loudest."
If your debts are crowding in on your life, both Kings suggest contacting a credit counselor through your credit union. Many credit unions have credit counselors on staff and those credit unions that don't can refer you to someone who can help. With restraint, reason, and some hard work, you probably can get your financial affairs back on a solid footing. But paying someone to do what you can do yourself, or expecting to get something for nothing, will only worsen your credit woes.
With debt settlement, all the responsibility lies on the consumer.
"The key is having the money, and with debt settlement, you get caught in the scam of giving someone else the money," adds Ken King. It sounds too good to be true, and it is.
"Don't wait until you're in deep trouble to ask for a financial checkup at your credit union," says Mike Schenk, vice president of economics and statistics at the Credit Union National Association in Madison, Wis. "In fact, the earlier you ask for a review, the better the outcome can be."