As credit card balances and delinquencies continue to rise, with the average credit card interest rate well above 20%, many Americans are finding themselves increasingly burdened by debt. In this precarious financial situation, people often look for solutions and ways out of the hole.
Debt settlement companies heavily advertise their services as an appealing alternative to bankruptcy. However, for most people struggling with serious debt, working with a debt settlement company is likely to leave them worse off than when they started.
In the majority of cases, declaring bankruptcy is a much better option that provides a truly fresh start financially. Before signing up with any debt settlement company, it’s important to understand the significant risks and drawbacks involved and why bankruptcy is usually a far superior choice. Here are the top 10 reasons to avoid debt settlement companies:
1. Debt settlement companies often engage in deceptive marketing practices.
Debt settlement ads make lofty promises about drastically reducing your debt, often claiming they can get creditors to settle for "pennies on the dollar." The reality is far different. Many debt settlement companies exaggerate their results and downplay the serious risks involved.
According to the Center for Responsible Lending, consumers typically have to settle at least two-thirds of their debt balance to complete a debt settlement program. Debt settlement companies often fail to clearly disclose the likelihood that consumers will be sued by creditors or have their wages garnished before settlements can be reached. The Consumer Financial Protection Bureau (CFPB) has taken action against numerous debt settlement companies for engaging in abusive and deceptive practices.
2. Debt settlement programs often take 2-4 years, and most people never complete them.
Debt settlement companies usually require clients to stop making payments to creditors and instead have them send money to the debt settlement company to build up funds for negotiating settlements. This process typically drags on for 2-4 years.
During this lengthy period, late fees and interest charges continue piling up, further increasing the debt owed. With most debt settlement programs, the debt settlement company cannot begin negotiating with creditors until the consumer has saved up enough money to fund the settlements, which can take years. As a result, the success rates of debt settlement programs are extremely low.
According to the CFPB, less than 10% of consumers who sign up for debt settlement programs actually complete them. The vast majority drop out, often ending up with higher debt balances than when they started.
3. Debt settlement companies charge high fees that eat up much of the savings.
Debt settlement companies present their programs as a big money-saver, but they charge hefty fees that significantly reduce any savings achieved. Fees typically range from 15-25% of the enrolled debt amount.
So, for someone with $30,000 in credit card debt, the debt settlement company might charge $7,500 in fees. That drastically cuts into any money saved through reduced settlements.
On top of that, some debt settlement companies tack on numerous additional fees, further chipping away at the benefits. With so much of the savings eaten up by exorbitant fees, much of the financial benefit promoted by debt settlement companies proves to be an illusion.
4. Debt settlement companies cannot prevent clients from being sued by creditors.
One of the biggest risks that debt settlement companies often gloss over is that their clients can still be sued by creditors and have their wages garnished while enrolled in debt settlement programs. Once a person defaults on their debts by following a debt settlement company’s advice to stop paying creditors, those creditors can sue to collect on the debts.
The debt settlement company has no ability to stop those lawsuits, which can result in judgments, wage garnishments, and liens on property. Even if the client completes the program, they may still be stuck with judgments that follow them for years. Debt settlement does nothing to prevent aggressive collection actions and lawsuits by creditors.
5. Debt settlement has a severely negative impact on credit scores.
Following a debt settlement company’s advice to intentionally default on debts wreaks havoc on a person’s credit score. Not only will all those accounts show as delinquent and in collections, but the total debt balance will balloon due to late fees and interest. The settled accounts will still show as derogatory items that were settled for less than the full balance on the person’s credit report for seven years.
Even if the debt settlement program is completed, the person will be left with a wrecked credit score that takes many years to recover from. Poor credit impacts the ability to obtain loans, the interest rates on any credit that can be secured, the ability to rent an apartment, and even employment prospects.
6. The IRS may consider forgiven debt as taxable income.
When a creditor agrees to settle a debt for less than the full balance owed, the portion of the debt that was forgiven may be considered "cancellation of debt income" by the IRS. For example, if a creditor agrees to accept $6,000 to settle a $10,000 debt, the $4,000 in forgiven debt is potentially taxable income. The consumer would then have to pay income taxes on that $4,000.
There are some exceptions, such as if the debt was discharged in bankruptcy or the consumer was insolvent at the time of the settlement. However, in many cases, a person in a debt settlement program ends up exchanging one debt for another in the form of a big tax bill.
7. Debt settlement companies cannot settle secured debts.
While debt settlement companies claim the ability to settle many types of debt, their programs are really only designed for unsecured debts like credit card balances and medical bills. They cannot settle secured debts where the lender has collateral they can repossess, such as mortgages or car loans. Borrowers in default on secured debts are likely to lose their house or vehicle.
Additionally, debt settlement programs often exclude federal student loans, which also cannot be settled for less than the balances owed. So, consumers with significant student loan or mortgage debt will not find debt settlement to be a comprehensive solution to their financial problems.
8. Debt settlement cannot stop interest charges and late fees from rapidly multiplying what is owed.
The typical debt settlement program takes 2-4 years before enough funds are accumulated to start negotiating settlements. During that lengthy period of default, interest charges and late fees on the unpaid debts continue escalating. As a result, consumers opting for debt settlement often see their total balances skyrocket before settlements can be reached, especially with the average credit card interest rate now over 20% annually.
Also, 85% of debt settlement clients end up paying more in fees and accumulated interest than they originally owed. Debt settlement programs can actually trap people in a downward spiral of compounding debt.
9. Upfront fees are illegal and a major red flag.
Some of the shadiest debt settlement companies demand fees upfront before providing any services. This practice is actually illegal under the Federal Trade Commission’s Telemarketing Sales Rule. The rule prohibits debt relief companies from charging fees until they have actually settled or resolved at least one of the consumer’s debts.
Any debt settlement company demanding fees upfront is breaking the law and should be avoided at all costs. Unfortunately, many still try to bilk desperate consumers with the illegal upfront fee tactic, as it allows them to make money without ever actually delivering any results for clients.
10. Bankruptcy provides a much quicker, safer, and more comprehensive way to eliminate debts.
For people overwhelmed by debt they cannot afford to repay, bankruptcy offers a vastly superior alternative to debt settlement that avoids the many pitfalls described above:
- Bankruptcy immediately stops all collection actions against the debtor, including lawsuits, repossessions, and wage garnishments.
- Bankruptcy eliminates all unsecured debts, including credit card balances, medical bills, and unsecured personal loans. Borrowers generally get to keep their homes, vehicles, and other essential property.
- Bankruptcy takes only 3-6 months to complete, versus 2-4 years for debt settlement.
- Bankruptcy fees are a small fraction of those charged by debt settlement companies.
- Debts discharged in bankruptcy are not considered taxable income by the IRS.
- While bankruptcy also negatively impacts credit, the effect is temporary. Credit scores generally improve quickly after completing bankruptcy and the bankruptcy filing itself is removed from the credit report after 7-10 years.
- Bankruptcy provides a true, comprehensive, fresh start, not a drawn-out negotiation process that often fails to settle all debts and leaves people vulnerable to lawsuits and garnishments.
While debt settlement companies often try to scare people away from bankruptcy, the reality is that for most people struggling with severe debt problems, bankruptcy is by far the quickest, safest, and most effective solution. The only ones who truly benefit from debt settlement programs are the debt settlement companies themselves, who rake in thousands in fees while providing questionable results that often leave their clients worse off.
Consult with an Experienced Bankruptcy Attorney
If you find yourself being crushed by overwhelming debt, resist the slick sales pitches and empty promises of debt settlement companies. Bankruptcy provides a much more comprehensive, secure, and rapid way to escape the downward spiral of debt and get a fresh financial start.
With the current rise in credit card balances, delinquencies, and interest rates, more Americans than ever may need to consider the bankruptcy lifeline on the path to re-establishing financial stability. Consulting with an experienced bankruptcy attorney is the best way to explore your options and determine if bankruptcy is right for you.
Don’t let debt settlement companies lead you down a costly path to nowhere. Choose the bankruptcy route to true financial recovery.
