debt settlement

Debt Settlement Also known as Debt Arbitration or Debt Negotiation, is an aggressive approach to debt reduction, which may be appropriate for debtors with serious amount of debt and are considering bankruptcy. A debt settlement agency negotiates with the creditors to settle the debt for a lower amount than owed, as the debtor saves their money for a lump-sum settlement payment. During the debt settlement process, the debtor will obtain a letter from the creditor stating the debt obligation was fulfilled. The creditor will typically make a report to the credit bureaus that the debt has been “Settled for less than full amount”, “Paid” or “Settled”.

Creditors will usually only settle for less than owed when the debtor is under serious financial strain because if the debtor chooses to file bankruptcy, then the creditor is at risk of receiving only a small portion of the original debt. If the debtor does not demonstrate financial hardship, the creditor may refuse to settle the debt and instead choose to pursue additional collection activities, including legal action.

Premise

A debt settlement is usually reached when a debtor is unable to fully meet his/her debt obligations due to financial hardships and attempts by the creditor to collect on the debt have failed. The creditor agrees to cancel part of the debt and accept the remaining sum as full repayment. Debt settlement is also called debt negotiation. Technically speaking, a debt settlement is the agreement while debt negotiation is the process through which both parties reach that agreement.

Consumers who use debt settlement are those who are experiencing legitimate financial hardships, cannot afford to repay their debts through debt management plans offered by consumer credit counseling agencies and who also want to avoid filing bankruptcy. For this reason, debt settlement falls between consumer credit counseling and bankruptcy.

Before looking to a debt settlement company consumers may want to contact their creditors to arrange payment plans since usually creditors are willing to work with the consumer when their account is past due. Often consumers are too emotionally involved to negotiate the best debt account settlements possible and choosing to work with a reputable debt settlement professional is their best option.

Debt settlement programs are provided by third party debt resolution firms who set up payment plans, and then negotiate settlements on behalf of the consumer. Typically, debt settlement programs are able to lower monthly payment contributions to approximately half of the typical minimum monthly credit card payments, and get consumers debt free in a short period of time.

Brief history of debt settlement

As a concept, lenders have been practicing debt settlement thousands of years ([1] Debt Forgiveness: Plainer Speaking, Please. by Stephen A. O’Connell). However, the business of debt settlement became prominent in America during the late 1980s and early 1990s when bank deregulation, which loosened consumer lending practices, followed by an economic recession placed consumers in financial hardships.

With charge-offs (debts written-off by banks) increasing, banks established debt settlement departments staffed with personnel who were authorized to negotiate with defaulted cardholders to reduce the outstanding balances in hopes to recover funds that would otherwise be lost if the cardholder filed for Chapter 7 bankruptcy. The settlements ranged between 25% and 65% of the outstanding balance ([2] Sworn Testimony of Dr. Robert Manning, author of Credit Card Nation).

In the late 1980's and early 1990's there were two companies (Berglas Hill & Ryan and Arbitronix Inc. that were in the forfront of third party debt settlement. However, the emphasis at that time was not on consumer debt, but commercial debt. While negotiation and debt settlement are not new and go back centuries, here for the first time in modern debt and credit history debtors had an option outside the law firm to level the playing field and have representation to take away the advantage held by Collection Agencies and Debt Collection law firms. Soon, the internet brought concept cloning and a plethera of commercial debt settlement companies emerged, some independent and some in groups under individual banners. A trade association for commercial debt settlement companies was formed but lasted but a few years to be replaced by what currently exists in the consumer debt field as set forth below.

What happened next: In the late 1990's and into the new millennium, consumer debt reached an apex and an all time high. Consumer Credit Counselers and similar non profit and for profit companies had been operating for some time, but not with a lot of press. Banks suddenly began to change the game and the key to debt counseling (reducing interest rates) was over. The alternative was another form of debt negotiation taken from the commercial world. Negotiation of credit cards and other consumer debt became very hot with companies springing up to sell the concept of getting out of debt by third party negotiation and in doing so, saving money. However, these companies were new to the game and had no negotiation experience. It created havoc forcing the FTC to step in in several instances and shut some companies down. Ever since, consumer debt settlement has been under the FTC microscope and questions remain about the legitimacy of their services. Unlike the creditor supported consumer credit counseling industry, debt settlement companies are usually for-profit companies that charge fees for their debt settlement related services. Another stark difference is that debt settlement companies do not negotiate reduction in interest rates, distribute monthly payments to creditors or report enrollment to credit bureaus. Instead, debt settlement companies negotiate reduction of the outstanding balance of each debt in exchange for a lump-sum payoff or short-term installment payoff.

Debt settlement process

Whether a debtor enrolls in a professional debt settlement program or negotiates settlements directly with creditors, the process is the same. The settlement company will require the debtor to sign a limited power of attorney, so they can negotiate on their behalf. The debtor will save up and set aside money to build up a settlement fund. Once enough funds to make a reasonable settlement offer accrue, the debtor or his/her professional debt negotiator will negotiate with the creditor for a reduced payoff amount, typically between 25% and 50% of the outstanding balance.

Once the creditor agrees to a settlement amount, payment is arranged and the account is considered settled-in-full (as opposed to paid-in-full). The debtor continues saving up and setting aside funds into the settlement fund to accrue enough funds for negotiating a settlement for the next willing creditor. Essentially, the process is a cycle of saving up and setting aside money, negotiating a settlement and paying the settlement.

Debt settlement compared to debt management plans through CCC

At one time there was confusion over whether debt settlement programs were the same as debt management plans serviced by the consumer credit counseling industry (Non Profit). With the introduction of the new Uniform legislation proposed for adoption in all 50 states the distinction between the credit counseling industry and the debt settlement industry has been made clear with the proposed legislation addressing both industries.

In a DMP, the credit counseling agencies works to lower the interest rate on the credit card account in hopes of lowering the monthly payment and causing more funds to go towards paying off the principal instead of the interest charges. The result of this is faster payoff of enrolled debts, within 60 months. The payments for different debt accounts are consolidated into one payment to the credit counseling agency who then distributes the payment to each creditor based on a scheduled repayment plan. Debt management usually charges a set up fee and a small monthly fee, however most are non-profit companies. They send out proposals to all creditors to propose new payment arrangements.

In a debt settlement program, the debt settlement company negotiates with the creditor to lower the outstanding balance of the debt. Usually to enroll in a program with a debt settlement company there is a power of attorney that must be signed. This allows them to contact all of the cardholder's creditors. The debt settlement company does not negotiate lower interest rates and does not distribute monthly payments to creditors. The debt settlement company, usually through a third party payment processor, arranges for paying off debts once a reduced-balance settlement agreement is reached between the debtor and the creditor. The debt settlement client does make monthly deposits into their settlement fund, usually managed by an independent, third-party payment processor.

Most creditors will negotiate with a third party to settle consumers debt. Before deciding on a debt settlement or debt management plan one may want to contact each of the creditors to see what can be done. Some creditors offer hardship programs to the consumers in an effort to prevent the account from charging off. Contacting the creditors directly will accelerate the collection process. It is best to contact the creditor directly only if you are financially able to make a payment as well as a monthly commitment for payment to the creditor. If you are not able to pay every month then you may be hurting yourself by contacting them, as they will accelerate the collection process, which may lead to a potential lawsuit against you. A debt settlement company's goal is to stay the collection process as much as possible to allow ample time for the debtor to store enough funds to pay a settlement. If the collection process has already been accelerated by your contact with them, then you may run into difficulty in settling your accounts.

Types of debts eligible for debt settlement

Normally, only unsecured debts, like credit card and medical debts, can be negotiated for settlement. Secured debts, like home and car loans, cannot be negotiated because the creditor usually can repossess the item purchased with the credit issued to the borrower. If the debtor decides to enroll in a debt settlement program serviced by a professional debt settlement company, the amount of debt enrolled must usually total at least between $7,500 and $10,000, depending on the company. Some companies accept smaller debt loads.

Debtor’s incentives

The debtor’s primary incentive for enrolling in a debt settlement program or engaging in direct debt negotiations with creditors is to pay off debts according to the debtor’s financial ability (which is likely strained due to financial hardships, such as unemployment, loss of income, medical expenses or other financial burdens). The other major incentive is to stay out of bankruptcy, which is reported on the debtor’s credit file and can remain on file for the next ten years.

Creditor’s incentives

The creditor’s primary incentive is to recover funds that would otherwise be lost if the debtor filed for bankruptcy. The other key incentive is that the creditor can often recover more funds than through other collection methods. Collection agencies and collection attorneys charge commissions as high as 40% on recovered funds ([3] Direct Recovery Associates). Bad debt purchasers buy portfolios of delinquent debts from creditors who give up on internal collection efforts and these bad debt purchasers only pay between 1 and 7 cents on the dollar ([4] MSN Money: Zombie debt collectors dig up your old mistakes). Collection calls and lawsuits often push debtors into bankruptcy, in which case the creditor often recovers no funds.

Common objections to debt settlement

There are five main objections to consumer debt settlement: damages credit, increased collection calls, possibility of lawsuits, tax consequences and the need to settle with all creditors.

Damages credit

The process of negotiating and reaching debt settlements with creditors requires the debtor to save up and set aside money into a settlement fund from which settlements are paid. However, due to the debtor’s financial hardship, the debtor is unable to make minimum payments towards credit card debts while saving up and setting aside money to payoff settlements. This inability to pay credit card bills while saving up money to payoff settlements results in the credit card company reported non-payment to credit bureaus (credit reporting agencies: Equifax, Experian and TransUnion).

Because payment history accounts for 35% of the FICO credit score calculation ([5] myFICO: What’s In Your Score), reports of non-payment to a debtor's credit file will lower the debtor’s credit score and reflect negatively on the debtor’s credit report. However 30% of one's FICO score is calculated by the amounts owed. So although debt settlement would hurt one's payment history, once the debt is eliminated it will improve the amounts owed portion of the FICO score (commonly called the debt-to-credit ratio) and also improve your debt-to-income ratio (used by future lenders).

The counter argument made by the debt settlement industry is that the good credit and the loose lending practices of the credit card industry enables consumers to accumulate an overwhelming amount of debt and all it takes is one financial hardship to interrupt the consumer’s ability to continue scheduled debt repayment. The other counter argument is that a consumer’s financial wellbeing is not always directly tied to their credit score and maintaining a credit score at the expense of basic needs is harmful to the consumer and the consumer’s family.

Increased collection calls

Another argument against debt settlement is that the failure to continue scheduled debt repayment results in increased debt collection activities that cause the debtor undue stress.

The counter argument made by the debt settlement industry is that many debtors are already being hounded by collection calls by the time they enroll in a debt settlement program. Many debt settlement companies offer assistance with alleviating collector calls and educate consumers about their rights as debtors as codified in the Fair Debt Collection Practices Act (FDCPA). Some companies actually change the phone number and address of their clients with the creditors to ensure that deal exclusively with the credit card companies.

While the FDCPA applied only to third-party debt collectors (not to creditors), some states passed legislation to supplement the FDCPA and to include creditors in their state consumer protection laws regarding debt collection.

Possibility of lawsuits

The fear of lawsuits is often an objection to debt settlement. Debt settlement companies instruct their clients to stop paying on their account, causing them to automatically go into default and making them vulnerable to judgments against them which could result in the garnishing of their wages and in some states a lien against property they own.

Tax consequences

Another common objection to debt settlement is that debtors whose debts are partially canceled outside the bankruptcy system will need to report the canceled portion of the debt as taxable income. (IRS Form 980)

The Internal Revenue Service considers $600 or more of forgiven debt as taxable income. The forgiving creditor must provide the taxpayer with a 1099-C tax form. This form will list the amount of forgiven debt and interest in Box 2. Taxpayers with portions of personal loans forgiven may not subtract the interest reported in Box 3 from the amount of reportable income on this form.

However, the IRS does not require taxpayers to report forgiven debt if the tax payer was insolvent at the time the creditor forgave the debt. Being insolvent means that the amount of a debtor’s debts are greater than his/her assets (how much money and property the debtor owns). However, the IRS adds that “you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent.” ([6] IRS Publication 525)

For example, if a taxpayer is $10,000 in debt and owns $3,000 in assets, he/she cannot exclude more than $7,000 of forgiven debt from his/her income tax. Any forgiven debt over $7,000 that year must be reported as taxable income.

Must settle with all creditors

Some creditors refuse to settle for an amount the debtor can afford. The more creditors a debtor has, the less likely the chance that settlement can be reached with all of them. Debtors who settle with only some of their creditors are still left with debts they cannot pay, so they must still file a bankruptcy or face the bill collectors and/or lawsuits.

Debt Settlement Trade Associations

Due to the rise of debt settlement as a debt relief alternative to bankruptcy, groups working in the industry established trade associations to help secure industry standards that will protect consumers against unethical business practices. These trade associations were also established to lobby state governments because many state legislatures are passing laws that restrict out-of-state companies from providing debt negotiation services to in-state residents. The three major trade associations are the United States Organization for Bankruptcy Alternatives (USOBA) [7] and The Association of Settlement Companies (TASC) [8]. Both of these organizations publish on their websites information about debt settlement and the debt settlement industry.

Individual Debt Settlement consultants can obtain thorough industry training and Certification as "Certified Debt Specialists" through The International Association of Professional Debt Arbitrators. (IAPDA) [9].

References

External links

Official website of Uniform Debt Management Services Act (UDMSA)