Debt settlement: how it works and what can go wrong
A settlement company tries to persuade creditors to accept less than the full balance. It can reduce what you owe, but the path there can be rough.
How a program usually works
- You enroll your unsecured debtsThese are typically credit cards and similar balances.
- You save in a dedicated accountYou make monthly deposits, often for 36 months or more, according to the FTC.
- The company negotiatesOnce enough money has built up, it makes offers to creditors.
- You approve a settlement and the fee is chargedA fee may be collected as each debt settles.
The risks to weigh
- Creditors don't have to negotiate, so some debts may never settle even if you make every deposit.
- Programs often ask you to stop paying creditors, which can damage your credit.
- Late fees, penalties and interest can keep growing.
- Creditors may sue. If they win, they may be able to garnish wages or place a lien on your home.
- Many people drop out before their debts settle.
- Forgiven debt may count as taxable income. An insolvency exception may apply, so ask a tax professional.
Fees
Avoid any company that wants payment before it settles a debt. The FTC's Telemarketing Sales Rule bans advance fees for these services when they're sold by telemarketing. Fees are often a percentage of the debt, so ask for the percentage and the estimated dollar amount in writing.
Questions to ask a company
- Are you licensed or registered in my state?
- What is the total fee in dollars?
- Which of my creditors do you work with, and which may refuse?
- What happens if a creditor sues me?
- Who holds my deposits, and can I withdraw them without penalty?
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Questions
Is debt settlement a good idea?
It depends on your situation. It's generally considered when you can't keep up with payments and other options won't work, because it carries credit and legal risks.
Can I settle debt myself?
Yes. The FTC notes you can contact your creditors directly at no cost and ask about a modified payment plan.
Do I have to pay tax on settled debt?
Possibly. Settled amounts can be taxable income and creditors may report them to the IRS. An exception may apply if you're insolvent.
Does debt settlement stop collection calls?
Not necessarily. Creditors and collectors may keep contacting you during a program.