Many people view bankruptcy as a last resort, putting it off or searching for alternatives and letting debts continue to spiral out of control. While it’s good to take responsibility for your debts and investigate other possible options before filing for bankruptcy, it’s important to fully educate yourself and understand the pros and cons of any alternative you consider–especially those that sound too good to be true.
Debt settlement sounds great to many people who have been struggling financially, because debt settlement companies often advertise with enticing language like, “Reduce balances by up to 50%” or “Debt free in as little as 24 months!” The idea of negotiating a settlement that allows you to pay debts, but to pay a much smaller amount and clear those debts much faster than expected has obvious appeal.
Unfortunately, debt settlement doesn’t always work out as advertised. And, there are serious potential consequences that you won’t see mentioned in those optimistic pitches.
Debt in California
Earlier this year, national lending clearinghouse Lending Tree issued a report on debt in California cities. Though Los Angeles came in relatively low in terms of average non-mortgage debt, several smaller area cities were among the “25 Most Debt Ridden Places in California (Excluding Mortgages).” Santa Clarita, Yorba Linda, Chino Hills, Rancho Cucamonga, Newport Beach, Thousand Oaks, Burbank and Gardena all made the list. Santa Clarita, with median non-mortgage debt of $30,009, came in second in the state.
So, it’s no surprise that many people are eager to find solutions, and may be susceptible to debt settlement company promises.
Debt Settlement Risks
Debt Settlement Companies Don’t Always Play by the Rules
There are bad apples in every industry, but the debt settlement industry has had more than its fair share of lawsuits and enforcement actions. Earlier this summer, the Consumer Financial Protection Bureau (CFPB) reached a $25 million settlement with Freedom Debt Relief. The California-based company is the largest debt settlement provider in the United States.
Though Freedom Debt Relief didn’t admit to any wrongdoing, the CFPB had alleged, among other things, that Freedom misled consumers into believing that the company could negotiate with all of the consumer’s creditors, despite knowing that major creditors such as Chase and American Express had long-standing policies against negotiating with debt settlement companies.
Further, the complaint alleged that after the consumer was enrolled, Freedom would often advise the consumer to negotiate directly with the creditor or creditors who would not negotiate with the debt settlement company. And, the CFPB said, Freedom instructed consumers to mislead creditors about their enrollment in the program and the source of the funds they were using to settle the debt. Then, the company would collect fees from the consumer for settlement of that debt, even though the company had not handled the negotiation.
This is just one of many governmental actions against debt settlement companies over the past several years.
Debt Settlement Can Destroy Your Credit
Most people considering debt settlement and other alternatives for managing debt have already fallen behind, which means that their credit scores may already be low and their credit reports may show some missed payments and collection accounts. But, debt settlement can make that worse, and substantially increase the amount of time it takes to rebuild.
The debt settlement model depends on building up a fund you can use to make partial, lump-sum payments to creditors. Of course, that takes time. And, since you already didn’t have enough money to go around, the debt settlement company will advise you to stop paying your bills and start paying that money into the settlement fund instead. But, it can take months or years to build up enough funds to settle your debts. While you’re paying into the settlement fund, you’re accruing more and more missed payments on your credit report.
Debt Settlement Can Get You Sued
For the same reason described above, debt settlement can trigger lawsuits and other collection actions. Your creditor is under no obligation to hold off attempting to collect because you are in a debt settlement program, especially if you have sufficient assets or income to allow the creditor to get more than it would through settlement negotiations. When you stop paying entirely, creditors may dial up their collection efforts.
When Debt Settlement Fails, You May be Worse Off than When You Started
While you’re paying into the debt settlement fund rather than paying your bills, you’ll continue to accrue interest, late fees, and perhaps collection costs on your debts. If your debt settlement plan falls apart–and many do–you will likely find yourself facing much higher balances than you started with. And, balances may have been accelerated, meaning that the full balance is due rather than just a monthly payment.
You May Get an Ugly Surprise at Tax Time
Many of those who do successfully complete debt settlement, or even settle one debt before abandoning the program, get an unpleasant surprise: new debt. That’s because the IRS considers most debt that’s been written off, or forgiven, to be gross income. Creditors who accept less than full payment may send a 1099-C, reporting the unpaid balance to the IRS. The more you’ve saved, the more you’re potentially paying taxes on. If you haven’t planned ahead for that chunk of extra taxes that will be due in April, the new obligation can easily throw your budget back into chaos.
Bankruptcy v. Debt Settlement
While a debt settlement program may take years to complete, a Chapter 7 bankruptcy case can often be completed in as little as four to five months. While debt settlement may reduce the amount you have to pay to unsecured creditors, Chapter 7 can eliminate many of those debts completely. While debt settlement companies typically charge large percentage based fees, a basic Chapter 7 bankruptcy case may be completed for a predictable flat fee. Lastly, the potential tax consequences of debt settlement are not present in a bankruptcy.
A Chapter 13 bankruptcy case takes three to five years to complete, which may be comparable to a debt settlement program. But, there are still significant differences. Perhaps the most important is that while debts continue to mushroom while you’re paying into a debt settlement fund, Chapter 13 bankruptcy freezes most late charges and other costs of delinquency, allowing you to catch up over time without additional penalties. Depending on your income, some unsecured debt may be eliminated or reduced in a Chapter 13 case, as well. And, the automatic stay, which is entered immediately when most consumer bankruptcy cases are filed, puts an immediate stop to collection calls, lawsuits, wage garnishment and other collection efforts. Another difference is that the creditors MUST participate in the Chapter 13 case or risk losing their right to collect anything at all. This is very different from debt settlement where participation by a creditor is voluntary.
To learn more about whether bankruptcy may provide the solution you’re looking for, call 877-895-1072 or fill out the contact form on this site to schedule a free consultation.