Beware Debt Settlement and Debt Negotiation

One of the main motivators for people to avoid bankruptcy is the perception that their credit will be ruined. Instead, these people will often take COSTLY actions that merely keep their bad credit for longer when they could have been laying the groundwork for good credit post-bankruptcy. Perhaps the most insidious of these non-bankruptcy alternatives is Debt Settlement and/or Debt Negotiation.

These schemes are often orchestrated in this fashion: A large monthly payment is made to the alleged debt-negotiator for their fees. People are usually told to establish a bank account in their own names at their own bank (to make them feel confident that they are not being robbed). They then write each of their creditors’ correspondence that tells the creditor to communicate solely with the debt-negotiator. The debt-negotiator supposedly then works out a deal with the creditors and they are paid with the money that the client is saving in his bank account. Sometimes debt negotiators charge a final fee which is a percentage of the money supposedly saved.

Put yourself in the creditors’ shoes. They know how these schemes work. Not all of them are willing to play though. It only takes one of them to say NO WAY and to turn around and sue. The first creditor that gets a judgment knows that it can execute against the wages and bank accounts of the debt settlement client. By definition, almost all people in debt settlement have some source of income, or they wouldn’t be in debt settlement in the first place. Creditors know this and not all of them are willing to sit idly by. They often sue. In fact, it is the experience of most bankruptcy lawyers that the people who get sued less are the people that just change their telephone number and drop out of reach, stopping payment on all of their creditors across the board and showing no payment activity on a credit report and have no known income or assets (we call this an "informal bankruptcy")! But engage in debt settlement/negotiation and the lawsuits start to fly!

Also, when a person stops making payments on credit cards, the late fees and accelerated interest can really rack up the debt each month. Any settlement of a percentage of the total becomes higher and higher. All the while, this debt is being reported on your credit report as late. If the creditors are receiving some token amount of money during the interim, the time that the debt remains on your credit report is extended as well as the statute of limitations for suing on the debt.

Finally, when a bona fide debt is forgiven or cancelled by a creditor, it will often generate “cancellation of indebtedness income.” This is reported on a 1099 that is sent to the IRS. People who actually succeed in settling their debts often find they have tax liability as a result (an accountant needs to be consulted though, this is not taxable income if the person is considered insolvent under the law).

If debt is successfully settled, then this debt is generally reported on the credit report as having been compromised for less than what is owed. Contemplate for a minute what this means across the board for someone that was otherwise a good Chapter 7 bankruptcy candidate. Assuming $40,000 of credit card debt that is actually successfully settled for $15,000 one year later: The client has spent $15,000, plus who knows how much to the debt negotiators, plus has potential tax liability. Assuming they are otherwise qualified for a Chapter 7 bankruptcy, one year later they could have had the $15,000 in the bank plus whatever they paid the debt negotiator ($5,000? $10,000?). They could have been building a new line of credit to ratchet up their credit score. With the cash in the bank and an ever-increasing credit score, they are already a better credit risk. Instead, by choosing the debt settlement route, they just put off their bad credit that much longer and have less cash and credit score for things like new car loans, etc.

Plus, pretend that you were a future creditor reviewing a credit report: Would you want to extend new lines of credit to someone that had just made you clip your debt in debt negotiation --- and who might just as well do so again -- and who still had the option of filing bankruptcy in the future? Probably not; at least for a long-time to come.

This is what happens in the rare case that debt settlement is actually a success. More than likely, the outcome will be money out the door to the debt settlement company and the inability to make the settlements in the first place, coupled with the high degree of likelihood that the person will be sued by one or more of their creditors. The ordinary outcome in debt settlement and debt negotiation is merely bad credit longer at a high price, plus a lawsuit. Why not just start with the solution of bankruptcy in the first place and make some real progress in your life.

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