Debt Settlement

Debt settlement, also known as debt arbitration, debt negotiation or credit settlement is an approach to debt reduction in which the debtor and creditor agree on a reduced balance that will be regarded as payment in full.

Debt settlement is often confused with debt consolidation. In debt consolidation, the consumer makes monthly payments to the debt consolidator, who takes a small fee and passes the rest on to the creditors; this way, creditors continue to receive payments each month. In debt settlement, the consumer makes monthly payments, out of which the debt settlement company takes its fees; the remainder is put into a "trust" or "special purpose" account. The creditors get nothing until they decide to settle. Furthermore, the debt settlement company usually instructs the consumer not to make any payments to creditors. The intended effect is to scare creditors into settling the debt for less than the full amount. Typically, however, creditors simply begin collection procedures, which can include filing suit against the consumer in court. As long as consumers continue to make minimum monthly payments, creditors will not negotiate a reduced balance. However, when payments stop, balances continue to grow because of late fees and ongoing interest.

Consumers can arrange their own settlements by using advice found on web sites, hire a lawyer to act for them, or use debt settlement companies. In a New York Times article Cyndi Geerdes, an associate professor at the University of Illinois law school, states "Done correctly, (debt settlement) can absolutely help people." However, some settlement companies may charge a large fee up front; or take a monthly fee from customer bank accounts for their service, possibly reducing the incentive to settle with creditors quickly. One expert advises consumers to look for companies that charge only after a settlement is made, and charge about 20 percent of the amount by which the outstanding balance is reduced.

Debt settlement differs greatly from credit counseling and debt management programs. It can be very risky, and have a long term negative impact on your credit report and, in turn, your ability to get credit. That is why the Federal Trade Commission and many states have laws or rules regulating debt settlement companies and the services they offer. Contact your state Attorney General for more information.

Debt settlement firms may claim they will negotiate with your creditors to reduce the amount you owe. Some debt settlement companies may claim that they can arrange for your debt to be paid off for a much lower amount, anywhere from 30 to 70 percent of the balance you owe. For example, if you owe $10,000 on a credit card, a debt settlement company may claim it can arrange for you to pay off the debt for less, say $4,000. Some debt settlement firms may also claim to be nonprofit.

Debt settlement firms often pitch their services as an alternative to bankruptcy. They may claim that using their services will have little or no negative impact on your ability to get credit in the future, or that any negative information can be removed from your credit report when you complete their debt negotiation program. The firms usually tell you to stop making payments to your creditors and, instead, send payments to the debt negotiation company. The firm may promise to hold your funds in a special account and pay your creditors on your behalf.

There is no guarantee that the services debt settlement companies offer are legitimate. There also is no guarantee that a creditor will accept partial payment of a legitimate debt. In fact, if you stop making payments on a credit card, late fees and interest usually are added to the debt each month. If you exceed your credit limit, additional fees and charges also can be added. This can cause your original debt to double or triple. All these fees will put you further in the hole.

While creditors have no obligation to agree to negotiate the amount a consumer owes, they have a legal obligation to provide accurate information to the credit reporting agencies, including your failure to make monthly payments. That can result in a negative entry on your credit report and in certain situations; creditors may have the right to sue you to recover the money you owe. In some instances, when creditors win a lawsuit, they have the right to garnish your wages or put a lien on your home. Finally, the Internal Revenue Service (IRS) may consider any amount of forgiven debt to be taxable income.

If you do business with a debt settlement company, you may be required to put money in a dedicated bank account, which will be administered by an independent third party. The account administrator may charge you a reasonable fee, and is responsible for transferring funds from your account to pay your creditors and the debt settlement company when settlements occur.

Depending on your financial condition, the amount of any savings you obtain from debt relief services can be considered income and taxable. Credit card companies and others may report settled debt to the IRS, and the IRS considers it income, unless you are "insolvent." You are insolvent when your total debts are more than the fair market value of your total assets. Insolvency can be fairly complex to determine. Talk to a tax professional if you are not sure whether you qualify for this exception.

Steer clear of debt relief companies that:

• charge any fees before it settles your debts
• guarantee they can remove your unsecured debt n/'
• tout a "new government program" to bail out personal credit card debt
• promise that unsecured debts can be paid off with pennies on the dollar
• tell you to stop making payments to or communicating with your creditors
• tell you it can stop all debt collection calls and lawsuits
• claim that creditors never sue consumers for non-payment of unsecured debt
• promise that using their system will have no negative impact on your credit report
• claim that they can remove accurate negative information from your credit report.

If you decide to work with a debt settlement company, be sure to check it out with your state Attorney General, local consumer protection agency, and the Better Business Bureau. They can tell you if any consumer complaints are on file about the firm you're considering doing business with. Also, ask your state Attorney General if the company is required to be licensed to work in your state and, if so, whether it is.