Debt settlement, although well-known, is not well-understood. For-profit debt settlement companies may advertise that they are a bankruptcy alternative and are able to settle your debts for 40 to 60 cents on the dollar or that they can help you eliminate debts without negatively affecting your credit. But, the truth is that very few actually do either of those things.
Many debt settlement companies are just scams, attempting to profit off consumers who are already in a vulnerable financial position. Unlike bankruptcy, debt settlement is not a legal process; it does not have a consistent, predictable outcome (discharge of debt). Rather, it is dependent upon the willingness of creditors to accept less than they are owed. Those who attempt to avoid bankruptcy through debt settlement services often end up filing for bankruptcy anyway.
An Overview of the Debt Settlement Process
Settlement companies generally operate under a similar structure:
- The consumer pays the settlement company periodically.
- The settlement company holds the payments in an escrow account until there is enough money available to attempt a settlement.
- The settlement company contacts the creditor(s) and attempts to negotiate a settlement on the consumer’s behalf.
Of course, it takes time to build the value of the escrow account. While that is happening, existing debts continue to accrue interest as well as penalties if the consumer has stopped paying the creditor. By the time the settlement company is ready to negotiate, the original debt has often increased by up to 50 percent, often the amount settlement company has promised to save.
Differing from bankruptcy, debt settlement programs seldomly eliminate all of a consumer’s debt. More commonly, companies will attempt to settle the smaller debts, justifying the fees they are charging, while rarely working on the balance of the consumer’s debts. Inevitably the plan falls apart and the consumer must seek bankruptcy protection after unnecessarily paying the debt settlement company thousands of dollars and wasting a lot of time.
Federal Investigation of Debt Settlement Companies
The promises, practices and lack of results of many debt settlement companies led the U.S. Government Accountability Office to conduct an investigation of the industry in 2010. In its findings, the GAO reported that “some debt settlement companies engage in fraudulent, deceptive and abusive practices that pose a risk to consumers.” Those deceptive practices included:
- Charging fees in advance of actually doing any work on behalf of the consumer
- Misrepresenting success rates as much higher than the settlement company has actually achieved
- Making verbal guarantees about their ability to reduce a consumer’s amount of debt
- Asserting falsely that they are government-backed or otherwise endorsed by the U.S. government
- Advising consumers that stopping payments on existing debts will have little effect on their credit score
Following the GAO’s study, the Federal Trade Commission banned prepaid debt settlement, requiring that a settlement company actually do work on a consumer’s behalf before they are allowed to charge. Six months after this rule-making, membership in The Association of Settlement Companies declined by 70 percent.
Unlike bankruptcy, working with a debt settlement company does not stop your creditors from contacting you directly, suing you to collect a debt or garnishing your paycheck for amounts owed. In fact, you can end up in a position much worse than when you started working with a settlement company: even further in debt.