When struggling to pay off debt, especially a high amount, it’s not uncommon to come across companies offering debt consolidation. However, many for-profit companies offering “consolidation” are actually selling a debt settlement service.
Debt settlement is where a third-party company can try to reduce someone’s debt by negotiating with their creditors or debt collectors on their behalf. While some debt settlement companies might be successful in lowering the amount of debt, these programs can be risky because of how they are structured.
Paying off less debt might sound like an easy win, but debt settlement can come with some big financial risks, possibly affecting the debtor’s credit score and ability to access credit in the future, and costing more along the way.
What Is Debt Settlement?
A debt settlement is just another term for a lump sum of money totaling less than what is currently owed, according to the Federal Trade Commission (FTC). Potential types of debt a person might want to consolidate into one bill might include credit cards, personal loans, medical bills, and cell phone bills.
Debt settlement companies negotiate with creditors in order to get a better payment plan or reduce debt and allow a lower payoff amount.
The debtor, in turn, might be required to make regular deposits to a dedicated bank account to save up for the eventual settlement.
During this time, the debtor is usually advised by the debt settlement agency to stop paying their creditors; this typically causes their account(s) to flow further into delinquency or even charge-off. This, in turn, can cause significant harm to their credit health and ability to access credit in the near and long term.
Debt settlement agencies generally charge a fee, which could be between 15% and 25% of the settled debt amount; however, the debt settlement agencies pay themselves first before paying down the debtor’s loan, a practice that ensures they are paid regardless of how the client fares. In addition, the debtor will have to pay taxes on the settled amount.
What Are the Pros and Cons of Working With a Debt Settlement Company?
Before jumping into debt settlement, there are some pros and cons a debtor might want to consider first. On the plus side, that anxiety about answering phone calls for fear a collection agency is on the line could go away.
In addition, all those debts could be consolidated into a single bill, so the debtor wouldn’t have to pay numerous bills a month on debt. And, of course, debt settlement could reduce debt long-term and help avoid bankruptcy.
However, there are some potential negative financial implications:
• Debt settlement companies typically encourage those who enroll in their services to stop sending payments to creditors during the negotiation period. This can seriously affect credit scores, incur late fees, and build up interest, actually digging a deeper hole. Creditors can also sue for repayment even when a debtor is working with a debt settlement company, and can take money directly from someone’s wages or force repayment in other ways.
• Creditors are not under any obligation to work with debt settlement companies. Even saving the monthly amount the programs require is no guarantee the two parties will be able to settle some of the debts.
• Debt settlement companies could still charge fees even if the entire debt wasn’t settled. While debt settlement agencies cannot charge fees until a settlement is reached, and at least one payment is made as part of the agreement, each time they successfully settle a debt with one creditor, the company can charge another portion of its full fee.
Beware of Debt Settlement Scams
Before deciding to enroll in a debt settlement program, it’s important to check the company with the local state Attorney General and local consumer protection agency. These agencies can help determine if there are any customer complaints on file about the debt settlement organization.
Also, a quick internet search of the company name and “complaints” could reveal any current lawsuits or deceptive and unfair practices. One easy method to find the top debt settlement companies is to look for those with good grades from the Better Business Bureau.
Some common red flags when researching any company promising to settle debt:
• Charging any fees before settling any debt. This is prohibited by the FTC’s Telemarketing Sales Rule.
• Promising to settle all debt for a specific percentage. Debt settlement companies cannot guarantee the amount of money or percentage of debt that could be saved by using their services. They also can’t guarantee how long the process will take.
• Claiming there is a “new government program” that they are assisting with.
• Guaranteeing to eliminate debt entirely.
• Explicitly giving instructions to stop communications with creditors, and not explaining the serious financial consequences of doing so.
• Saying they can stop all debt collection calls or lawsuits.
• Starting enrollment without any review of an individual’s financial situation.
The FTC advises people should avoid any sort of organization, whether they are offering credit counseling, debt settlement, or any other financial service, that fails to explain the risks associated with their programs, makes grandiose promises, and asks for any money upfront.
Debt Settlement Alternatives
In contrast to some debt settlement companies that are profit-driven, reputable credit counseling organizations might be available to offer help with managing money and debts, developing a budget, and providing free educational tools and workshops.
Counselors should be certified and trained and help develop an individual plan for solving money problems. One place to start could be this list of nonprofit agencies certified by the Justice Department, which offer counseling and debt management plans.
Credit counselors might suggest a debt management plan, where one monthly payment is made to the credit counseling organization, and then they make all of the individual monthly payments to creditors.
Counselors do not typically negotiate any reduction in debts owed, but could help lower monthly payments by working to increase the loan terms or lower interest rates.
A debtor could take the DIY approach and talk to the creditor personally, even if negotiations for a lower rate or debt reduction have not worked in the past. Instead of paying a company to talk to a credit card company or other debt creditor on their behalf, remember that anyone can do it themselves for free.
The conversation could be approached with the goal of figuring out a modified payment plan to reduce payments to a manageable level.
Creditors and their collection agencies are typically willing to negotiate, even if they have already written off a debt as a loss.
According to the Consumer Financial Protection Bureau, many creditors and debt collectors will not negotiate how much they are willing to settle for, meaning debt settlement companies likely can’t get better terms than an individual could get by talking to the creditors themselves.
A balance transfer could also help when it comes to consolidating credit card debt. A balance transfer is when someone moves debt from one credit card to another, usually taking advantage of a 0% interest offer on the newer card. While the 0% rate only lasts for a specific amount of time, this offers the opportunity to pay off more of the credit card debt during that promotional period since new interest isn’t accruing.
Rather than looking to a debt settlement company to fix high debt, another alternative that could be considered is a fixed-rate personal loan, which might be easier to manage and could help save money in the long run.
By consolidating qualifying high-interest debt into one low-interest personal loan, a borrower could simplify by only having one fixed monthly payment.
For someone interested in debt consolidation, SoFi personal loans are free of fees and offer plenty of different term lengths. An unsecured personal loan could help simplify debt, since it provides a set loan term and interest rate, so there are no surprise increases in monthly payments.
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