Debt Settlement – How It Works, and Scams to Avoid
Debt Settlement is when you get really far behind on your debts and then attempt to ‘settle’ with the creditor for less than you owe. So, if you owe a credit card $40,000, we might try to get that debt settled for $15,000. Sometimes a creditor will give a great deal. Other times the creditor will play it tough and only give a small discount. Each creditor has its own policy for settlement. To make things more complicated, each creditor regularly changes the policy.
Though we have a great track record settling debts for our clients, it is not easy to predict (or guarantee) a particular outcome. Any debt settlement agency that tells you they can ‘guarantee’ a certain amount of savings is probably lying to you. If you read the small print- they will tell you there is no guarantee. That being said, we usually settle for below 50% of what is owed. I have gotten as low as 5% and regularly gotten 10% deals. But the credit cards have gotten tougher over the years. A really important part of debt settlement is knowing when to settle.
After a while, the credit card company will sell the debt to someone else. Sometimes the best settlement is just before that transfer. Other times, we want to wait until the debt is owned by another company. Another important thing to understand about debt settlement is that the truly GREAT deals only happen when you can make a lump sum payment. So, if you want to settle your debts, but can’t come up with large chunks of money, you are probably not going to have a great outcome.
Debt Settlement Examples by the Numbers
| Debt | Settlement Amount | Attorney Fees | Initial Savings |
|---|---|---|---|
| $40,000 | $15,000 (Debt savings before fees = $25,000) | $5,000 | $20,000 |
But then there is the IRS.
Some banks will issue you a 1099 for the debt you got eliminated. So, if you are taxed on the $25,000 you saved, depending on your tax bracket you could owe money to the IRS come tax-time. If you are in a 25% tax bracket you would be paying $5,000 more to the IRS. Most settlement companies don’t tell you this except in the small print.
There are some situations where you are not liable for tax debt from debt forgiveness. But you would need to speak with me in concert with a tax professional to know whether you can avoid that liability.
Taxes on debt forgiveness= $5000.
Total savings= $15,000.
It is still a good deal, saving you $15,000. But there is a lot that cannot be predicted until you are in the debt settlement process. For instance, some creditors will settle for 10%, but others will only settle for 80%. So, if you have tough banks or known assets, your Settlement Amount might be $30,000 instead of $15,000.
Then with the fees and taxes, it isn’t such a great deal at all! This is why I never push debt settlement unless there is no other option.
What About Debt Settlement Plans with Monthly Payments?
Most of the time, a debt settlement program that takes monthly payments from you is THE BIGGEST SCAM GOING! A lot of debt settlement companies will say “pay us $300 per month (or some other amount) and we will take care of your debts” They will show you a schedule of how everything will work. BEWARE. This is often a scam.
First of all, companies that do this usually take your first $1500 to $2600 of payments and put it in their pockets. Then they start applying your payments to a fund where they wait until you have built up enough money to settle. But if you owe $20,000 to a bank, it will take YEARS before you will build up enough money to really settle your debt. Ask yourself how long it would take you to save up $10,000? What happens during that time? The creditor will sue you, garnish your wages, freeze your bank account, contact your employer and friends and family etc. Your debt settlement company will show you more ‘small print’ where they tell you they do not represent you in legal actions. Then you will end up filing bankruptcy anyhow.
What about the thousands of dollars you paid the debt settlement company? The money is gone. There is no lawyer who will take your case to sue the debt settlement company for a few thousand dollars. But worse than the money is the time you lost. If you had just filed bankruptcy from the start, you could have been done in a month and your credit could be well into recovery.
Many people who call me for help have been in debt settlement for years. Don’t get me wrong, I love doing debt settlement. But if a client can qualify for bankruptcy, it is almost always better to file bankruptcy. And I won’t take monthly payments for debt settlement except in rare exceptions. Long-term debt settlement plans just don’t usually work and I don’t want to get hired for something that is doomed from the start. If you can’t qualify for Chapter 7, and you don’t have funds for Debt Settlement, then you should consider Chapter 13 bankruptcy (which is a court-managed debt repayment plan) or additional options we provide.