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The Truth About Credit Card Debt Settlement

By , CardRatings contributor
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The Truth About Credit Card Debt Settlement (Part 2)

As an increasing number of people struggle to pay their bills, debt settlement companies are thriving. You can find their ads promising to settle your debts for pennies on the dollar anywhere.

If you’re drowning in debt, those ads can be pretty attractive. But are they for real? And how will settlement affect your credit rating? Debt settlement is controversial. In fact, the Federal Trade Commission held an all day conference in late 2008 to discuss the industry. Here’s a basic guide to debt settlement, with tips to help you figure out if it makes sense for you.

What Is Debt Settlement? 

Debt settlement is also known as “debt negotiation.” It’s also sometimes referred to as debt consolidation, but that’s misleading since your debt is not consolidated in any way. Settlement programs have been around for many years, but the industry has been exploding recently as consumers find themselves deeper and deeper in to debt. With debt settlement, you negotiate to pay back a portion of what you owe, usually in a lump sum payment, to resolve a debt that you simply can’t pay back in full. While some ads may tout repayments of as little as ten cents on the dollar, a more typical settlement is somewhere around fifty percent of the amount owed. Here’s an example of how settlement can work:

Jack owes a total of $50,000 on six credit cards. His issuers have been lowering his credit limits and raising his interest rates. In addition, he is no longer earning overtime at work, so he just can’t keep up with his minimum payments. He talked with a credit counseling agency, but the monthly payment they proposed was too high and left no room in his budget for any emergencies. He also considered bankruptcy, but does not feel right about not paying back debts he incurred.

Jack works with a reputable settlement company (we’ll discuss how to find one in a moment) and stops paying on his credit cards. Instead, he starts putting that money aside into a savings account. As he starts falling further and further behind, creditors start offering to let him pay off his bills for less than the full amount. He starts to pay off some of the debts, while waiting for better offers from others. He takes any extra money that comes in – a tax refund, for example – and uses it to help eliminate another debt. Over the course of the next eighteen months he reaches settlements with all his creditors and pays a total of $28,000 (including the settlement companies’ fees) to get out of debt.

This method can work well for someone who has more unsecured debt than they can afford to pay off in three to five years, but either can’t or won’t file for bankruptcy. It has its drawbacks, though. First, creditors will not settle if you are paying your bills on time. So that means you must stop paying to even be eligible for a settlement offer. (Of course, if you’ve already started to fall behind, then you may be a prime candidate for debt negotiation.) And there may be legal or tax implications. Other the other hand, it is a process that allows consumers to pay as much as they can afford on their debts, and it allows creditors to get something, rather than nothing if the consumer files for bankruptcy. In fact, many large credit card companies that refused to settle in the past are offering very attractive settlements now in order to reduce losses.

How is Settlement Different Than Credit Counseling?

Credit counseling and debt settlement are two completely different approaches. Most credit card companies work with credit counseling agencies. They will often encourage consumers who are having trouble paying their bills to enroll in a Debt Management Program (DMP) offered by a reputable credit counseling agency. That way, they get paid back 100% of the debt, plus interest. But most creditors don’t like to work with settlement companies (or at least don’t admit publicly working with them), and a few will even send consumers to litigation if they find out the borrower has hired a settlement firm. If you can realistically afford to pay back your debt through credit counseling, it’s a better choice. Your credit rating will not be as severely affected as it will by settlement and, as long as you stick with your payment program, you’ll be out of debt in three to five years. But if a credit counseling agency can’t offer you affordable monthly payments, then settlement may be your only other choice.

Bankruptcy vs. Debt Settlement

If you file for bankruptcy you will either discharge (wipe out) most or all of your debts in a Chapter 7 case, or pay back part of your debts over several years in a Chapter 13 plan. Bankruptcy provides legal protection that settlement does not. Once you have filed, your creditors cannot sue you, or even contact you to collect while the bankruptcy is in progress. Of course, in recent years it has become far more difficult for some debtors to qualify for this a Chapter 7 bankruptcy to wipe out the majority of their debts. Some consumers are forced to file Chapter 13 bankruptcy, instead, and make court-ordered payments for the next five years. Or they may have to give up assets to help satisfy the debt. It’s always a good idea to talk with a bankruptcy attorney to find out what your options are. Visit Nacba.org or ABI-world.org to find a consumer bankruptcy attorney in your area.

How Will Debt Negotiation Affect My Credit?

A settlement will negatively impact your credit rating. Overall, settlement is similar to bankruptcy as far as your credit is concerned. That’s because you will have to stop making your payments, and you may even have to allow debts to go into collections before creditors will negotiate. However, unlike bankruptcy, debt settlement will never appear in the public record. And when you are out of debt, you can begin to rebuild your credit rating. 

Taxes and Settlement

The IRS classifies forgiven debt as income. (That’s true even if the settled amount included interest or penalty fees.) If you owe $10,000 and settle for $6,000, the difference is considered to be taxable income. This tax will, however, often be waived if you can prove insolvency at the time of making this settlement. An accountant can tell you more about the conditions which must be met to settle.

How Can I Find A Reputable Debt Settlement Company?

Be cautious. There are a lot of companies which offer these kinds of services. Some are unscrupulous, while others simply have not been in business long enough to establish a track record. There are several things you should avoid when considering one of these firms:


1. A company with high upfront fees. Some of the best settlement offers come in the first few months after you stop paying. But if you’ve spent all your money on fees to the settlement company, you won’t have any money left to settle! All companies charge something up front, but it’s best to work with a company that uses the “performance based” fee model, where they get paid based on their success negotiating settlements.

    2. Heavy sales pressure. Some debt negotiators are paid very high commissions (from those high upfront fees!), and don’t care whether the debtor will be successful in the long run.

    3. Misrepresentation. Avoid companies that make it sound like you are in a “payment plan” with your creditors, or that propose a “four-year plan” to settle your debts. If you cannot settle your debt within 24-36 months using settlement, you run the risk of being sued.

    Tip: Better Business Bureau ratings are often not helpful in evaluating settlement firms. The BBB’s current rating system prevents any settlement company from earning more than a “C” rating, and some are given “D” ratings, even if they have no unresolved complaints.

    For more help deciding if debt settlement is the best option for you, check out the Consumer Recovery Network. You may also want to review Stop Debt Collectors: How to Protect Your Rights and Resolve Your Debts, by Gerri Detweiler and Mary Reed, for advice on how to deal with unfair collection tactics.

    If you are interested in the self-help approach, you can find tips at ZipDebt.com. On a related note, if you have been unsuccessful at negotiating a lower rate on your existing credit cards, you might want to consider shopping for a new low rate credit card. As a reminder, you can compare low credit cards on CardRatings.com!

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