The Dangers of Debt Settlement

Be Careful Choosing Debt Settlement to Deal With Your Debts

Scissors cutting credit cards
••• © Walker and Walker / Stone / Getty

You may have read about debt settlement as an alternative to bankruptcy or a solution to your debt. The ads sound especially promising and usually read something like:

"Reduce your debt up to 65%!"

"Get out of debt in less than six months!"

Who wouldn't want to take advantage of a solution like that? Debt settlement promises to reduce your debt by negotiating with your creditors, but the effect on your credit isn't explained so clearly.

If you're considering debt settlement as a solution to debt problems, get the full story first.

How Debt Settlement Works

The process starts when you call a debt settlement company and tell them about your situation. You give the names of the creditors and the amount you owe. The debt settlement company then gives you an estimate for reducing your debt along with a new, lower monthly payment. As advised by the settlement company, you stop paying your creditors and instead send payments to the debt settler.

The debt settlement puts your monthly payments into a savings account. Once the account has grown to a certain amount, the debt settlement company calls your creditors and begins negotiating a settlement. (The settlement is an amount lower than your full outstanding balance.)

If the creditor agrees to a settlement amount, the settlement company pays the creditor and assesses a fee for the settlement.

The settlement fee might be a flat fee or a percentage of the debt that was cancelled.

What's So Bad Debt Settlement?

On the surface, debt settlement doesn't sound so bad. You pay the debt settlement company who, in turn, pays your creditors. In the end, everyone gets paid and you're able to move on with your life.

Remember the part where you stopped payment to your creditors while a settlement is negotiated? That's the part that will come back to haunt you.

Creditors don't typically settle debts unless they're a few months past due. That means you have to stop paying your accounts and allow them to become past due.

Meanwhile, late payments are reported to the credit bureaus, your credit score drops, and you might begin receiving collection calls. The late payments will remain on your credit report for up to seven years. Until you replace the negative payment history with some positive information, you'll have difficultly getting new credit cards and loans. You may even have a hard time getting a job or a good insurance rate.

If the debt settlement company successfully settles with your creditors, the delinquent information isn't erased from your credit report. Instead, your account is updated to something that shows you settled, e.g. "Charged-Off Settled" Or "Paid-Settled." A settled status isn't nearly as good as a "Paid in Full" account.

After debt settlement, it may take a few months or even a few years to rebuild your credit and be approved for unsecured credit.

You could owe taxes on settled debts.

The Internal Revenue Service (IRS) treats forgiven debts as income and expect you to pay income taxes on it. Creditors are supposed to send you a Form 1099-C for reporting cancelled debts, but you're supposed to include the debt in your tax return even if you don't receive the form.

Debt Settlement Alternatives

If you're current on your accounts, or even just one or two months behind, and you want to maintain a good credit score, then debt settlement is not for you.

Consider consumer credit counseling which will allow you to enter into a debt management plan with your creditors. There's a possibility to reduce your monthly payments and you'll still be able to pay your balance in full. As long as your payments continue to be made on time each month, consumer credit counseling does not hurt your credit.

You can work out your own payment plan with your creditors. If you've missed one or two payments, ask your creditors if they have a hardship program for customers who are having financial difficulty. (Tip: use the word "hardship" in your conversation.) You can often get a temporary reduction – six months to one year – in your monthly payment and interest rate.