Credit Card Debt Settlement: What is It, How Does It Work, and What to Watch Out For?
Credit card debt settlement is an agreement between an indebted consumer and a creditor that entails the consumer submitting a lump-sum payment for the majority of what they owe in return for the company that owns the debt forgiving part of the outstanding balance as well as certain fees and finance charges.
Unfortunately, the need to settle debt arises far too often. Consumers consistently spend beyond their means and eventually see their balances spiral out of control when interest charges and fees become unsustainable.
"Credit cards have two properties that can prove irresistible to consumers," says Michael I. Norton, associate professor of business administration at Harvard Business School and co-author of Happy Money: The Science of Smarter Spending. "First, they allow us to have nearly anything we want right away. ... Second, they reduce what researchers call the 'pain of paying.' Forking over cash is painful because it makes the loss so salient, whereas credit cards make everything feel 'free' since the actual payment happens months after the purchase."
Settling amounts owed is one way to escape serious credit card debt, but it’s neither the only one nor is it without its own perils. Not only do a lot of shady companies operate in the debt settlement space, but debt settlement and the circumstances that bring it about can also be detrimental to your credit standing.
We’ll explain these issues in further detail below:
First of all, it’s important to note that credit card debt settlement is only a viable option if you have already defaulted on what you owe or are close to doing so (i.e. you’re experiencing serious financial hardship). In other words, you have to be around 180 days behind on your credit card payments to even qualify for consideration.
With that said, there are two basic types of debt settlement: 1) do it yourself debt settlement; and 2) service-assisted debt settlement. You can also attempt to settle the following types of debt:
- Credit card debt
- Store card debt
- Unpaid medical bills
- Unpaid phone bills
The fundamentals, however, are the same regardless of which type of debt settlement program you choose or what type of debt you’re trying to settle. Basically, the debtor approaches the creditor with a partial payment offer (anywhere from 30-80% of the full amount owed) and asks that the remaining amount be forgiven. The creditor can then accept, reject, or counter this offer.
Once both parties agree on a settlement amount, the party that owes the money will be required to submit the respective lump-sum payment within a specified timeframe. Doing so will satisfy and officially close the account in question. Not doing so will likely increase the odds of the creditor suing for the full amount owed.
Tax & Credit Score Implications:
Anyone contemplating a debt settlement must also factor potential tax obligations into their budget, as creditors are legally required to report forgiven debt (excluding forgiven fees and finance charges) to the IRS, which considers it to be income since you’ll have technically borrowed the forgiven amount without paying it back. You are therefore likely to receive a 1099-C form in the mail after a debt settlement agreement goes through, so make sure not to discard any communications from the IRS.
Let’s say, for example, that you defaulted on $1,500 in outstanding credit card debt - $500 of which is fees and finance charges. If you reach a settlement agreement that requires you to submit an $800 payment, the $200 in forgiven principal will be taxable. If you’re in the 25% tax bracket, you’ll therefore owe $50 to the IRS, meaning your settlement was effectively for $850, rather than $800.
It’s also important to note that since you are likely to have defaulted on your account prior to reaching a debt settlement agreement, information about the default will remain on your major credit reports for seven years from the date that you became 180 days late. Your credit score will suffer during that timeframe.
How Your Creditors Will React:
If you are trying to settle debt that you have already defaulted on and are not making payments towards, then your creditors will continue to contact you as often as they did prior to entering the debt settlement program.
If you start withholding payments from your creditors on debt that you have not already defaulted on, then you should expect:
- Assessment of penalty fees.
- A potential increase to your interest rate.
- Multiple calls and letters from your creditors, trying to convince you to start paying again.
- Your creditors may also file a lawsuit against you, which could lead to wage garnishments if a judgment is entered in the creditor’s favor prior to a settlement being reached with the creditor.
Therefore, it’s important that you do NOT enter a debt settlement program unless you really do not have the resources to pay off your debt OR have already defaulted on the debt and the creditor has not filed a lawsuit against you.
As you can surmise from the above overview, there are both advantages and disadvantages to credit card settlement. For your reference, we will sum up these pros and cons below.
|• Save money||• It’s not guaranteed to work|
|• Avoid the threat of a lawsuit||• You must already have defaulted (If you’re planning to default in order to qualify for debt settlement, then you can count credit score damage as one of the negatives as well.)|
“Debt settlement services are truly a ‘buyer-beware’ circumstance,” says Mike Flynn, professor of consumer protection law at the Nova Southeastern University Law Center. “The damage to a person's credit rating is the consequence of using these services, but if it allows a person to survive in this economy and eventually rebuild credit quicker without bankruptcy, then maybe that makes some sense.”
There are a wide range of companies that deal in debt settlements, and their legitimacy ranges just as far.
Not only do many attorneys specialize in debt settlement and offer free consultations, but there are also certain nonprofits that handle debt settlements for qualified consumers in their area service. While you might assume such debt settlement professionals to be effective and trustworthy (and they often are), that’s certainly not a foregone conclusion.
“I would counsel consumers to be wary of even non-profit debt settlement entities even though the non-profit label can make such entities appear to be a safe harbor for the financially and emotionally distressed consumer,” Alexandra P. Everhart Sickler, an assistant professor of law at the University of North Dakota School of Law, told WalletHub. “Remember, these entities have overhead costs, including salaries. They need the ‘donation fees’ consumers pay in exchange for debt settlement services in order to operate, so they are equally motivated to bring in as many consumers as possible.”
With that said, consumers must be even more diligent when dealing with a for-profit debt settlement company or credit “repair” service (the ones that typically advertise the most). A good portion of these companies are known to be scams, and even those that are considered somewhat reputable won’t be able to do anything for you until you’ve defaulted.
“Occasionally they may provide added value to the debtor's situation over and beyond what they charge (always keep an eye on this value of services consideration), but if the debtor wants to use one of these services, I certainly would advise him to select one only from the United States Trustee's list of approved counseling companies,” says Steven A. Schwaber, a Los Angeles-area bankruptcy attorney. “The field is rife with such settlement companies that are merely shills or front organizations for the credit industry and do not have either the debtor's interests or even fairness at heart.”
That’s especially important to note because many debt settlement services will charge hefty fees for their attractive promises, only to sit on the payment that you give them until your credit is ruined before even beginning negotiations with your creditor – if they ever actually do so. It’s therefore usually best to avoid debt settlement companies entirely.
“As a consumer advocate, my perspective is that the bad apples in the for-profit debt settlement industry still greatly predominate over those offering good service at a fair price,” Gary Klein, partner at the Boston-based consumer law firm Klein, Kavanagh & Costello, told WalletHub. “The risk of overpaying for services that don't pan out so far outweighs the potential for advantageous debt settlements, that consumers should avoid for-profit debt settlement services at all costs.”
As a result, many consumers choose to effectively serve as their own debt settlement companies, opting for a DIY debt settlement. This is a great option, provided that you do the requisite research and are able to remain both objective and civil when dealing with your creditor.
Hiring a Debt Settlement Company
All in all, the decision to hire a debt settlement company boils down to the following factors:
- A debt settlement company is likely to know which creditors are more inclined to settle and for how much.
- A debt settlement program will provide you with the discipline to save money every month that you can use as leverage when negotiating. Remember that no creditor will want to make a deal with you unless you are ready to make a lump-sum payment.
- Hiring a debt settlement company will cost you a lot of money.
- Many debt settlement companies are known to be scams and do not have your best interests at heart.
If you do ultimately decide to hire a debt settlement company, this is roughly how things will work. Once accepted into a debt settlement program, consumers generally make payments to both the debt settlement agency and into an independently managed savings account. The payments to the debt settlement agency covers their fees and are typically non-refundable. The money from the independently managed savings account is leveraged by the debt settlement agency to negotiate with your creditors and should remain liquid and refundable in case you decide to withdraw from the settlement program.
Debt settlement companies typically charge 10-15% of the amount of debt that you are trying to settle for their services. So, if you are trying to settle $10,000, for example, the fee to the debt settlement company will be between $1,000 and $1,500. You should definitely get quotes from multiple agencies as well as verify their policies and fee structures prior to making a final decision.
In that regard, it’s important to note that certain regulations govern what information debt settlement companies are required to provide to their customers as well as how they are allowed to assess fees. These restrictions – established by the Federal Trade Commission’s Telemarketing Sales Rule – applies to for-profit debt relief companies that market their services over the phone as well as when a consumer contacts a debt relief company in response to advertising.
Debt settlement companies may not assess fees until they have:
- Renegotiated, settled, or changed the terms of a consumer’s debt. If the consumer in question has multiple balances across creditors, the settlement company must prorate its fees in accordance with the work it completes (i.e. not charge a full fee for only settling one balance).
- Established a written agreement with the consumer as to the work that will be done, how long it will take, and how much it will cost.
- Received at least one payment from the consumer to be used for debt payment purposes.
Before a consumer enrolls in a debt settlement program, the settlement company must notify them about:
- How long the settlement process will take.
- What fees it will charge.
- What impact the process will have on the consumer’s credit standing.
- The fact that the “dedicated account” used to hold a consumer’s debt payments as well as the interest it accrues will be owned by the consumer, who can withdraw the funds at any time without penalty. The settlement company must also not have any affiliation with the institution managing the account or receive any sort of referral fee from this institution (which must be federally insured).
- Debt settlement companies are also banned from misrepresenting their success rates, potential outcomes, or non-profit status.
People often wonder why they should even bother with a debt settlement given that they’ll already be in default and the damage to their credit standing will already be done. However, debt settlement can be a wise decision for two reasons: 1) It eliminates the threat of a lawsuit, which might force you to pay your full balance; and 2) Paying what you owe is simply the honest thing to do.
With that said, every situation is different and you must carefully evaluate the specifics of your own in order to make an informed decision regarding debt settlement. If you ultimately decide to take the debt settlement route, note that much like an attorney representing you in a legal matter, there are no guaranteed results in a debt settlement program.
“Debt elimination or settlement is rarely successful,” says Jeremiah E. Heck, partner in the Ohio-based consumer law firm Luftman, Heck & Associates. “In my experience, the companies might be able to settle a debt or two, but in a very high percentage of cases, the consumer will eventually be sued by a creditor. At this point, there is little to nothing the debt settlement company is able to do for the consumer. Further, many of these types of companies charge large upfront fees that take away the ability of the consumer to offer settlements to the creditors.”
If you take nothing else from this article, it’s important for you to remember four things:
- Debt settlement is an amended payment agreement that entails submitting a one-time payment for part of what you owe in return for the creditor/debt collector forgiving the rest.
- Your account must be in default (or close to it) in order for you to qualify for debt settlement.
- Avoid debt settlement companies and either do it yourself or work with a reputable non-profit. If you choose to pursue a DIY debt settlement, make sure you’re properly prepared and follow our tips for achieving a positive result.
- Forgiven debt (only principal, not fees and finance charges) is taxable as income.