Debt set­tle­ment is usu­ally a bad al­ter­na­tive to fil­ing bank­ruptcy

The Atlanta Journal-Constitution - - BUSINESS - By Liz We­ston Nerdwal­let Liz We­ston is a CFP and author of “Your Credit Score.”

Debt set­tle­ment isn’t the Wild West in­dus­try it was a decade ago, when peo­ple rou­tinely paid hefty up­front fees to com­pa­nies that failed to de­liver any re­lief.

Thanks to in­creased reg­u­la­tion and en­force­ment, the much smaller num­ber of set­tle­ment com­pa­nies that re­main of­ten do what they prom­ise: per­suade at least some of a bor­rower’s cred­i­tors to for­give part of the debt, typ­i­cally in ex­change for a lump sum pay­ment.

Sev­eral peo­ple I’ve in­ter­viewed lately re­ported pos­i­tive ex­pe­ri­ences with debt set­tle­ment, so I de­cided to take an­other look at the in­dus­try. It turns out that hir­ing a ne­go­tia­tor could be a rea­son­able al­ter­na­tive to bank­ruptcy for some. But debt set­tle­ment is not as con­sumer-friendly as the in­dus­try presents it, and some of the peo­ple who praised the com­pa­nies didn’t fully un­der­stand their al­ter­na­tives or the longer-term con­se­quences of set­tling debt.

One wo­man didn’t re­al­ize she would face a tax bill on the for­given debt.

A man opted against bank­ruptcy in part be­cause he er­ro­neously thought he would lose per­sonal pos­ses­sions.

An­other wo­man was shocked at how far her credit scores tum­bled and how much in­ter­est she was charged when she ap­plied for a car loan.

Where debt set­tle­ment falls short

Here are some of the big­gest prob­lems with debt set­tle­ment:

Ne­go­ti­a­tions can take years. Cus­tomers are told to stop pay­ing their credit cards, loans and other debts and fun­nel money in­stead into a sav­ings ac­count. Free­dom Fi­nan­cial Net­work, the largest debt set­tle­ment com­pany, says half of its cus­tomers even­tu­ally set­tle at least 75 per­cent of their debt, but the process usu­ally takes three to four years. Mean­while, cus­tomers risk be­ing sued over their debts, although Free­dom says the per­cent­age of its clients be­ing sued is in the sin­gle dig­its.

The math of­ten doesn’t work. Debts are nor­mally set­tled for 45 per­cent to 50 per­cent of the cur­rent bal­ance, which is of­ten higher than the ini­tial bal­ance be­cause of late fees and in­ter­est. The typ­i­cal debt set­tle­ment fee is 20 per­cent of the debt at the time of en­roll­ment. The amount of for­given debt is usu­ally re­ported to the IRS and is usu­ally tax­able as in­come. If the bor­rower is in the 25 per­cent fed­eral tax bracket, the to­tal cost of the set­tle­ment can equal 90 per­cent or more of the orig­i­nal amount owed.

Set­tle­ment com­pa­nies also claim that bank­ruptcy is harder on credit scores. In re­al­ity, both pro­cesses of­ten drop scores into the mid-500s, well into the “poor” range on the typ­i­cal 300-to-850 credit score scale. Credit scores can be­gin to recover im­me­di­ately after ei­ther process is com­plete. The dif­fer­ence, of course, is that Chap­ter 7 bank­ruptcy typ­i­cally takes months, while debt set­tle­ment typ­i­cally takes years. Plus, bank­ruptcy halts col­lec­tions ac­tiv­ity, in­clud­ing law­suits, and can end wage gar­nish­ments.

“The one op­tion that shines above all the rest is bank­ruptcy,” says Steve Rhode, a for­mer credit coun­selor who runs the Get Out of Debt Guy ad­vice site. “It’s the cheap­est and fastest and the best way to re­build your credit.”

When does debt set­tle­ment make sense?

Nei­ther debt set­tle­ment nor bank­ruptcy is a good op­tion for peo­ple who can pay their bills. Those who want to lower their in­ter­est rates can re­fi­nance with a per­sonal loan if they have de­cent credit or sign up with a non­profit credit coun­selor’s debt man­age­ment plan if they don’t.

So when might debt set­tle­ment make sense? When your debt is un­man­age­able and you can’t or won’t file for Chap­ter 7 bank­ruptcy. If your only bank­ruptcy op­tion is a Chap­ter 13 pay­ment plan, which typ­i­cally re­quires five years of pay­ments be­fore any re­main­ing bal­ances are erased, set­tle­ment could re­solve your debts a bit faster so you can be­gin to build credit again.

Peo­ple should re­search their al­ter­na­tives care­fully and not rely on what one debt re­lief provider tells them about the oth­ers, Rhode warns. . “Peo­ple need to go through and com­pare the op­tions.”

Liz We­ston is a colum­nist at NerdWal­let, a cer­ti­fied fi­nan­cial plan­ner and author of “Your Credit Score.”

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