What are the pros and cons of using a debt reduction company? Do all creditors work with debt settlement firms?
As far as using a debt reduction service, what are the pros and cons? Do some credit card companies refuse to work with debt settlement or negotiation businesses? How do I determine whether a debt settlement or negotiation company is a good one?
(Updated Nov. 2011) Your questions cannot be answered in convenient one-sentence responses, and as a result I encourage you to take the time to understand each of my answers below.
Debt reduction is also known as debt negotiation or debt settlement. It is one of several debt relief options available to consumers who find themselves drowning in unsecured debt, such as credit card debt, medical debt, deficiency balance, payday loan, or other consumer debt. All debt resolution options -- whether it be bankruptcy, credit card counseling, or debt settlement -- have pros and cons. Like other debt relief options, debt settlement / negotiation has positive and negative aspects you need to understand.
Pros and cons of debt settlement
Instead of making monthly payments to your creditors, these programs negotiate lump sum settlements with your creditors, frequently reducing your debts by 50% to 60% of your balances. Debt Settlement programs usually take two to three years to complete, which is typically the fastest option for a consumer to reach debt freedom.
While debt settlement can be the most effective way to get out of debt, anyone considering debt settlement needs to be aware of its negative aspects, such as:
- It reduces your credit score during the program and can take a year or two after completion to rebuild your score. The score reduction is not permanent, and credit scores are known to self-repair when the accounts are resolved. Because credit score calculations are based primarily on an consumer's recent credit history, as the accounts are settled and age they tend to have less of an impact on the overall credit score. Typically, the fact that a consumer is working with a debt settlement company does not appear on a consumer's credit report. As a result, the report will appear as if the individual settled the debt with the creditors directly, as opposed to filing bankruptcy or using a credit counseling program to eliminate the debt. Visit What You Need to Know about Your Credit Score to learn more.
- Debt settlement can lead to collection activity against you. This is because the you choose to stop making regular payments to your creditors, when you enroll in a settlement program. As a result, creditors can make multiple phone calls and send you collection letters. For many consumers, a creditor's collection calls can be more stressful than the drop in their credit score.No honest settlement company guarantees they can stop collection attempts completely. Creditors and collection agencies have a right to collect on a debt owed. However, depending on the state where one lives, there are regulations that can help reduce call volume and collection activity. This can be accomplished using a cease communication form-letter that demands the creditor or its collection agent communicate through letters rather than phone calls. Some states have more consumer friendly laws than others, so the effectiveness of a cease communications letter varies. Consumers in debt are protected by the Fair Debt Collection Practices Act, a by a federal law that limits the activities a collection agent and creditor who collect on debts can take when contacting a consumer. Effective debt settlement firms will be able to assist you in reducing the headaches caused by collection agents and creditors. To learn more about collections please see Collections Advice.
- Not every creditor may be willing to settle for less than than the face value of your account. All creditors have a stated policy of not negotiating or settling debt. The stated policy is in place to discourage consumers from using debt settlement companies, and to encourage consumers to pay the full balance on their accounts. However, the reality is that all creditors have a history of resolving accounts.
- A potential tax liability is a final drawback to debt settlement / negotiation. Under federal tax law, forgiven debt is considered income. A creditor is required to submit a 1099 to the IRS for any debt forgiveness exceeding $600 in value. Therefore, a consumer would be wise to consult with a certified tax preparer, CPA, or tax attorney with respect to the implications of being taxed on the forgiven debt. Generally speaking, many creditors do not issue 1099s, and as a result consumers do not pay additional taxes on the forgiven debt. Consumers who do receive 1099s do not see a significant tax penalty because their severe financial hardships are usually the result in significant loss of income, or events that allow for tax credits. IRS Form 982 covers certain hardship situations that may exempt or offset the tax liability caused by a large 1099 debt forgiveness.
Creditors' Perspectives on Your Accounts
Before we explore the reasons why a creditor may not resolve a particular account, let us first review how creditors look at their accounts receivables.
First, accounts with regular payments are considered current. When an account becomes 120 to 180 past due, the creditor is required to reclassify the account as non-current. Most creditors will then place a discounted value on past-due accounts and either sell them to a collection agent or transfer them to a department at the creditor that tries to collect on delinquent accounts.
As an account ages, creditors will tack on fees and interest as a form of negative reinforcement to encourage the consumer to pay-off the account quickly. This means an account balance can increase over the course of the program. However, when the account is settled it is usually much less than the original balance.
Generally speaking, the greater the amount of time since the last account activity occurs, the less the account is valued. Some collections agents will buy debt accounts from creditors at steep discounts -- 5 to 50 cents on a dollar. Therefore, when an account is settled with a collection agent the agent often makes a profit even with a steep cut from the face value of the account.
As mentioned, creditors have a stated policy of not settling accounts for less than the face value. The existence of debt settlement companies is proof this policy is words only. However, creditors will choose to refuse to resolve some accounts for less than the face value. Which accounts a creditor will not negotiate is a result of many factors. For example, if an individual made a large purchase, balance transfer, or cash advance shortly before defaulting a creditor may see this as an intent to commit fraud that the creditor does not wish to forgive.
Another reason a creditor may not want to settle is that they may believe the consumer has sufficient assets or income to pay the debt owed. It is difficult for a creditor to determine a consumer's liquid assets with accuracy. Some creditors have a policy of selling past-due accounts quickly, and others are more patient and negotiate sharply. There is no science to when and why a creditor will not want to settle.
A significant advantage of working with a settlement / negotiation company is the history negotiators accumulate with each creditor. A debt settlement company's underwriting department can assess the risk of a creditor not settling.
How to Find a Reputable Debt Settlement Company
The American Fair Credit Council(AFCC)is the leading industry trade group in the debt settlement industry. AFCC members are required to follow a strict code of conduct, which is strictly monitored and enforced by the AFCC.
As the AFCC explains, the "AFCC is ONLY for those willing to abide by the AFCC's new Code of Conduct that emphasizes full compliance with the federal and state rules regulating what we do. There is now a bright line between good actors - and bad." USOBA, another debt settlement industry trade group, does not require its members to comply with the FTC rules, such as not charging customers upfront fees, so Bills.com does not recommend any USOBA member debt settlement firms. Don't be scammed by a debt settlement firm that charges upfront fees!
AFCC members must remain fully compliant with the rules issued by the Federal Trade Commission that regulate the debt settlement industry that went into effect in October, 2010. These rules were created to protect the consumer. For instance, anyone now enrolling in a debt settlement program is not required to pay a service fee to the settlement firm until his or her account has been settled. This makes settlement an even more attractive option for the consumer.
Pointedly ask any debt settlement firm you speak with if they are compliant with the FTC rules. If anyone expects you to pay a fee up front, you should look for help elsewhere.
AFCC Mystery Shopping
The AFCC 'mystery shops' its members. Mystery shopping is where the AFCC contacts a member and acts as a consumer. The AFCC then grades the member on how it represents its services. Some debt settlement companies have been barred from the AFCC for failing to meet the requirements of proper disclosure not only on paper, but also on the telephone (which is the most common way consumers enroll).
There are 2 tiers of membership (Regular Member and Accredited Member). Accredited Members must go through a thorough onsite audit (sales, marketing, customer service, negotiations department, HR, etc.) every year conducted by BSI Group to make sure company is complying with the AFCC Code of Conduct, including full compliance with FTC Rules.
The second step to finding an effective debt settlement / resolution company is to determine if the company is an International Association of Professional Debt Arbitrators (IAPDA) member. The IAPDA requires that its members have their debt consultants and account executives pass a certification test that requires them to understand and communicate the pros and cons of debt settlement to their clients.
Finally, learn how long the firm has been in business. A long history is good because, as previously mentioned, a company with long history will have experienced underwriters and negotiators who have demonstrated an ability to negotiate effective settlements with a variety of creditors.
The Better Business Bureau and the Debt Settlement Industry
The Better Business Bureau (BBB) once rated debt settlement companies the same way the BBB rates other industries.
Recently, the BBB adopted a policy that it will not give debt settlement companies a favorable rating. This is due to that fact that the industry lacks uniform regulation currently, and therefore it is difficult to assess debt settlement firms according to objective standards. The other issue cited by the BBB for debt settlement / resolution to work a consumer must be in a default status with creditors. In default, creditors are encouraged to negotiate an account. A consumer in default means the consumer is in breach of contract with their creditor. The BBB looks disfavorably at this aspect of debt settlement / resolution programs.
However, by the same logic, the BBB should give negative ratings to all attorneys who practice bankruptcy or family law, because both consult with their clients about breaching contracts with creditors and others.
The BBB came under scrutiny by Los Angeles Times columnist David Lazarus in his archived article Grading firms on a peculiar curve. What he and others are concerned with is the lack of consistency in the BBB's grading policy.
BBB is not an arm of the federal or state governments. The BBB is a private organization that supports itself by collecting membership fees from the members it rates, and therefore it would be wise for consumers to take into account a business's membership or non-membership when considering a business's BBB rating. See the Wikipedia Better Business Bureau Criticism section for more on the BBB's business ratings.
Choosing a debt settlement / negotiation company
First, consumers should weigh the benefits and the costs of debt settlement / negotiation before deciding if it is the right option. See the link to the resource cited below for a discussion of debt resolution options.
Second, when considering a debt settlement company, look at the company's longevity. Make sure it is a member of AFCC and IAPDA.
Third, avoid a company that requires you to pay all fees up front. Debt settlement companies provide the service, so it is understandable they charge a fee. But make sure that the fee is rolled up into monthly payments and are spread out over the course of the program. That way you will see settlements occur while paying fees.
For more information about debt settlement / negotiation and other debt resolution options, see What Are My Debt Consolidation Options?
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Mortgages, credit cards, student loans, personal loans, and auto loans are common types of debts. According to the NY Federal Reserve total household debt as of Q2 2022 was $16.15 trillion. Housing debt totaled $11.71 trillion and non-housing debt was $4.45 trillion.
According to data gathered by Urban.org from a sample of credit reports, about 26% of people in the US have some kind of debt in collections. The median debt in collections is $1,739. Student loans and auto loans are common types of debt. Of people holding student debt, approximately 8% had student loans in collections. The national Auto/Retail debt delinquency rate was 4%.
Collection and delinquency rates vary by state. For example, in New Mexico, 13% have student loan debt. Of those holding student loan debt, 10% are in default. Auto/retail loan delinquency rate is 6%.
Avoiding collections isn’t always possible. A sudden loss of employment, death in the family, or sickness can lead to financial hardship. Fortunately, there are many ways to deal with debt including an aggressive payment plan, debt consolidation loan, or a negotiated settlement.