If financial stress is keeping you awake at night and you’re watching a lot of late-night television, you’ve probably seen advertisements for a variety of “solutions” to your debt problems. It’s easy to get drawn in by big promises of debt negotiation or debt consolidation when you’re under stress and feeling hopeless, but many of the companies targeting people in financial stress won’t really help. In fact, it may be difficult to understand exactly what it is that they’re offering, or how those choices may impact your finances in the short and long term.
Understanding Debt Consolidation
We recently wrote about debt consolidation loans, which sometimes offer a solution for people who have too many different minimum payments to meet each month but still have good credit and the ability to make regular payments. As the term suggests, a debt consolidation loan combines (or “consolidates”) outstanding debts into one loan. You use the loan to pay off the smaller debts and then make just one monthly payment to the new lender.
That’s what you should be able to expect whenever someone talks to you about consolidation. The language is clear:
Consolidate: “to bring together (separate parts) into a single or unified whole”
Unfortunately, some debt relief providers, especially those who make flashy promises on television and radio and those who show you online advertising that promises huge reductions in your debt, sometimes blur the lines.
For example, one of the nation’s largest debt settlement companies bills itself as “the nation’s top-rated debt consolidation company.” But, if you visit that company’s debt consolidation information page, you’re advised to talk to a “trusted financial advisor” if you’re considering a debt consolidation loan. Then, you’re invited to contact the company to speak with a “debt professional.”
Another of the nation’s largest debt settlement companies–one that was sued by the Consumer Financial Protection Bureau (CFPB) and settled–says their representatives will “help you weigh the options.”
What Do These Companies Really Do?
Many of the companies pitching “debt consolidation” actually offer and hope to steer you toward debt settlement programs. We’ve written about the dangers of debt settlement programs in the past, but here’s a quick overview of how debt settlement works and why it can do more harm than good.
Debt settlement companies often advertise that they can substantially reduce your debt by negotiating with creditors on your behalf.
What may not be immediately obvious to the consmuer is that this process can take years, and during that time the consumer faces a number of risks, including damaging their credit report and/or credit score and creditor lawsuits. The Federal Trade Commission (FTC) warns consumers about both the risks of debt settlement programs generally and the possibility of debt settlement scams.
Debt Negotiation in Action
The first thing most debt settlement companies do after signing up a new client is to advise the consumer to stop paying his or her debts. That may come as a relief if you’ve been struggling to keep up payments and juggle priorities for months or years, but it may also make you nervous. It should.
Debt settlement providers negotiate with creditors to settle your debt for less than you owe. But, they can’t enter into an agreement with the creditor until you’ve deposited enough money with the company to cover that settlement. So, during the initial months when you’re making payments to the debt settlement company rather than to your creditors, your creditors are getting nothing.
The problem is, your creditors haven’t agreed to this. That means while you’re sending money to the debt settlement company, your creditors will likely continue to bill you, send collection notices, call you, make negative reports to the three major credit bureaus, and add interest and late fees. They may even close your account, turn your debt over to a collection agency, or sue you.
That’s just one problem. Another problem is that debt settlement math doesn’t often work out the way it sounds like it will when you talk to a representative or listen to an advertisement. Let’s say the company says it believes it can settle a debt for about 60% of the balance. That sounds great: if your debt is currently $10,000, you’ll save $4,000, right?
First, you have to remember that fees and interest will continue to accumulate while you pay into the debt settlement fund. If the $10,000 debt is a credit card balance with a 24% annual interest rate and a $35 monthly late charge, the balance 12 months after enrollment could be nearly $3,000 higher. Let’s conservatively say the balance has increased by $2,000.
Now, settling for 60% of the outstanding balance means settling for $7,200, not $6,000. Your expected $4,000 in savings on your original $10,000 balance is now $2,800.
If that was the end of the calculation, you might still be satisfied. You paid more than you expected, but still saved 28%, right?
Debt settlement companies aren’t allowed to charge up front fees, so they typically charge on a percentage basis. How this is calculated varies from company to company, but it’s often 15-25% of the enrolled balance. In this scenario, your enrolled balance would have been $10,000. AT 20%, your fee for settlement of this debt would be $2,000. That means after a year of staving off collection calls, watching your credit score decline and holding your breath while you waited to see whether you’d get sued before the debt was settled, your net savings would be $800.
These companies often “forget” to mention the tax consequences related to debt negotiation. Any debt that is “forgiven” is considered to be gross income by the IRS. In other words, you have to pay tax on the debt that the creditor agreed to waive. There went your net savings on the debt, unless your tax preparer says you qualify for one of the limited exceptions to debt forgiveness income tax.
Understand Your Debt Relief Options
If you’re considering debt consolidation or debt negotiation, educate yourself about debt consolidation loans and work with reputable providers. If you’re just starting to explore your options, there are many ways to get reliable information. The FTC and CFPB both make extensive consumer information available on their websites. A non-profit credit counseling agency can explain your options without a sales pitch. Or, you can talk with a debt resolution attorney.
If you have funds to make monthly payments as you would in a debt settlement program, you may find that Chapter 13 bankruptcy would allow you to achieve the same ends without escalating fees and collection actions, continued negative credit reporting, and the ongoing threats of lawsuits and wage garnishments or the uncertainty about which debts would be addressed and how much that would cost.
To learn more, call 877-439-9717 to schedule your free consultation.
M. Erik Clark is the Managing Partner of Borowitz & Clark, LLP, a leading consumer bankruptcy law firm with offices located throughout Southern California. Mr. Clark is Board Certified in Consumer Bankruptcy by the American Board of Certification and a member of the State Bar in California, New York, and Connecticut. View his full profile here.