Do Debt Settlement Programs Work?

For consumers struggling with high credit card or other unsecured debt burdens they cannot pay off through normal means, debt settlement may seem like an attractive option. Debt settlement companies advertise that they can negotiate your balances down substantially, making debt repayment more affordable. However, debt settlement is a major undertaking with risks involved. Evaluating whether these programs can realistically accomplish their promises requires understanding the debt settlement process, success rates, and potential drawbacks.

How Debt Settlement Programs Work

Debt settlement firms offer to negotiate payoffs of unsecured debts like credit cards, medical bills, and personal loans for less than the full outstanding balance. The process generally works like this:

Clients Pay into Escrow Account

You make monthly payments to an escrow account rather than creditors, building up a lump sum. You stop making payments to creditors.

Settlements Are Negotiated

After sufficient funds accumulate, the debt settlement company contacts creditors and seeks to negotiate a reduced settlement, often for 30-60% of the balance.

Creditors Are Paid from Escrow

Once a negotiated settlement is agreed to, funds from the escrow account are used to pay the creditor per the settlement terms.

Fees Are Collected

The debt settlement company collects service fees from the client’s escrow account, ranging 15% to 25% of the total debt enrolled.

This facilitates settling debts for potentially far less than owed. But it also impacts creditworthiness if accounts become delinquent.

Debt Settlement Companies and State Regulation

The debt settlement industry remains largely unregulated nationally. However, some states have enacted laws and oversight:

• 18 states + DC require debt settlement company licensing. This includes CA, FL, IL, and NY.
• Licensing mandates surety bonds, adherence to fee limits, and certain client contract terms. It provides oversight mechanisms.
• Even in unregulated states, reputable companies voluntarily comply with standards like limiting fees until after settlements.
• Trade associations like the American Fair Credit Council promote best practices in self-regulation. Members must abide by ethical codes.

While debt settlement lacks national statutory regulation, state efforts and voluntary compliance provide some structure. But uncontrolled shady operators still persist.

Potential Debt Settlement Outcomes

Debt settlement does not guarantee any particular end result. Potential scenarios include:

Ideal Settlements

You could settle multiple accounts for 30% to 60% less than the balances, becoming debt free at substantial savings.

Partial Settlements

Some accounts settle, while others remain unresolved. Overall debt is reduced partially but not eliminated.

Dropped Accounts

Settlement attempts fail for most or all accounts, leaving debts unpaid and still owed in full. Companies collect fees regardless.

Lawsuits and Collections

Missed payments during settlement enrollment result in creditors suing or assigning accounts to collections agencies. Settlements cannot move forward.

Bankruptcy

The burden of debts and damage to credit ultimately necessitates declaring bankruptcy for a fresh start.

Outcomes run the gamut from ideal to worsening the situation significantly. Expectations must be realistic.

Debt Settlement Pros

If successful, debt settlement provides major financial benefits:

Debt Elimination

Settling multiple accounts for pennies on the dollar can resolve unpayable debt burdens and provide closure.

Save Substantially

Ideal settlements let you pay a fraction of balances owed, with remaining forgiveness freeing up cash flow.

Avoid Bankruptcy

By settling debt, bankruptcy and its severe credit impacts may be averted as a last resort.

Outsource Negotiations

Working directly with creditors can be stressful. Settlement companies navigate the process for you.

Lump Sum Payments

Some creditors prefer accepting a single lump payment from settlement funds rather than small installment payments over time.

Tax Implications

Settled credit card and other unsecured debt is not taxable income, unlike forgiven mortgage debt.

If executed well, debt settlement agreements deliver on promised savings and debt reduction.

Debt Settlement Cons

However, debt settlement also comes with considerable downsides and risks:

Fees Result in Higher Cost

Heavy service fees assessed on total debt enrolled can increase your total repayment costs significantly compared to just paying off the balances yourself over time.

Credit Score Damage

Missed payments and settled accounts show up negatively on your credit reports, tanking your credit scores. This can take years to recover from.

Tax Consequences

While credit card debt is not taxed when settled, other types like medical and personal loans may be treated as taxable income when reduced.

Lawsuits and Collections

Lawsuits, calls from collectors, and asset seizures can result from delinquent accounts during settlement enrollment prior to any resolution.

Settled Balances Remain

Even after settling, creditors can still legally pursue you for the remaining balance they agreed to forgive. Debt is not formally invalidated.

Scam Risk

Disreputable companies take fees but deliver no results. Restricted state regulation provides little recourse.

These downsides make debt settlement a highly risky endeavor with success not guaranteed despite high costs.

Key Considerations for Success

Certain factors determine whether debt settlement delivers the advertised benefits:

Timeliness

Settling accounts before they are sent to collections or sued upon produces better results. Delaying too long reduces options.

Settlement Funds

Having sufficient funds to offer lump sum settlement payments makes creditors more willing to negotiate substantial discounts. Lowball offers may be rejected.

Type of Debt

Credit card and other unsecured debt is easiest to settle. Secured debts like auto loans and mortgages are far less negotiable.

Company Reputation

Well-established debt settlement firms with extensive creditor relationship experience achieve higher settlement rates. Fly-by-night companies fail to deliver.

Client Commitment

You must be willing and able to make regular escrow payments in full and on time for success. Inconsistent payments derail the process.

With the right circumstances and honest professionals, debt settlement could resolve otherwise hopeless debt burdens. But unscrupulous companies overpromise, and the risks may outweigh potential rewards. Proceed with eyes wide open.

Alternatives to Debt Settlement

Other options exist beyond debt settlement to tackle unmanageable debt:

Debt Management – Work with a non-profit credit counseling agency to consolidate debts and negotiate reduced interest rates on payments.

Debt Consolidation Loan – Take out a new loan at lower interest rate to pay off multiple debts and reduce overall interest costs.

Balance Transfer Credit Card – Transfer account balances to a new card offering 0% introductory interest for 12-18 months to pay down principal.

Minimum Payments – Continue making minimum payments on time over years until balances are gradually eliminated.

Bankruptcy – Declare Chapter 7 or Chapter 13 bankruptcy for much of debts to be discharged. but at severe credit damage.

Do It Yourself Negotiation – Contact creditors directly to propose your own settlements without paying settlement company fees.

Depending on your specific debt situation, alternatives may provide debt reduction without some of the risks and drawbacks inherent to professional debt settlement programs.

The bottom line is debt settlement services often overstate their abilities to permanently resolve debts. Success depends on many factors. While settlement could be the lifeline needed for crushing high interest rate balances, the consequences of failed or partial settlements must be prepared for as well. Realistic expectations are critical when assessing if debt settlement aligns with your circumstances and tolerance for risk.