Debt Settlement: How It Works and Why It Will Cost You More

For someone struggling with debt, debt settlement can look like an attractive rescue hatch. The truth is, debt settlement companies often leave consumers with more debt than they started with in the first place.

Instead of turning to a debt settlement company, most consumers would be a lot better off if they sought the services of a good nonprofit credit counseling agency.

What is Debt Settlement?

The term, “debt settlement” just means settling a debt or reaching a settlement with a creditor. However, the way the phrase is used in the world today is to describe an industry that has a very particular business model.

debt settlement ad

A typical debt settlement ad

Debt Settlement companies target people who are really struggling with credit card debt. The typical debt settlement client has about $30,000 in credit card debt and around five or six credit card debts outstanding. Ads for debt settlement companies will warn you that if you’re just making minimum payments on your credit cards, you’re going to be paying for the rest of your life. You’re never going to get ahead. So the ads say what you should do is default on those credit cards. Once you default, typically after 90 or 180 days, the creditor will do what’s called charging off the debt, where for accounting purposes they say they don’t expect to be able to collect the debt. They will then typically either sell debt or pass it off to a debt collector. It’s at that point that the debt settlement company will try to negotiate on your behalf.

Five Things to Know About Debt Settlement

  1. To enroll in a debt settlement program, you must default on all your debts.debt settlement credit card debt 5 things
  2. Debt settlement programs last about four or five years.
  3. Even if a significant portion of your debt is settled, the rest will likely grow larger, leaving you with more debt than you had to begin with.
  4. While debt settlement may seem like a good way to get out of debt, ruined credit, lawsuits, tax liability, and continued growth of debt are all factors that can leave debt settlement customers worse off than they were before.
  5. Non profit credit counselors have your best interest at heart, while debt settlement companies are trying to make a profit from your debt. While many credit card companies refuse to deal with debt settlement companies, credit counselors can get up-front agreements from your creditors. They can also help you build a debt management plan that leads to true freedom from debts. To find a non profit credit counselor, click here to visit the National Foundation for Credit Counselors website.

Debt Settlement Companies Can’t Bill You Until They’ve Settled at Least One Debt

debt settlement must settle before billA key change in debt settlement introduced in the telemarketing sales act in 2010 prevents debt settlement companies from receiving any payment from a customer until they’ve settled at least one debt.



We spoke about debt settlement with Ellen Harnick, Senior Policy Counsel at the Center for Responsible Lending.

“Basically, the way these companies used to do business is they’d say, OK, start paying us,” said Harnick. “You’ve got to pay us up front $2,000 or $6,000 or whatever that number was. Typically it was a percentage of the amount of debt you had. Once you’ve paid enough to cover our fee, then we’ll start trying to settle debts for you. And so a lot of people, once they’d paid the $2,000 or $6,000, they couldn’t pay any more. And now they can’t get their money back, and they haven’t paid a single creditor.”

The telemarketing sales act changed this practice, requiring debt settlement companies to settle at least one debt for a client before sending the client a bill.

Also see: Debt Collectors: 14 Tips for Dealing with Collection Calls

Debt Settlement is Likely to Make Your Debts Worse

debt settlement most debt not settledAccording to Harnick, debt settlement doesn’t work. In fact, it most often leaves victims with more debt than they had to begin with.

Several companies in the debt settlement industry formed a trade association called the American Fair Credit Council (AFCC). Their lead member is a company called Freedom Debt Relief, part of a network of companies called the Freedom Financial Network. They fought against the FTC rule, but they live by it. According to Harnick, they don’t try to get around the rule, but they say now that the rules enforced, the debt settlement industry is a great industry.

“They say nobody gets hurt,” says Harnick. “How could you possibly get hurt? You don’t pay a penny until we settle a debt, and any client of ours has received a benefit because if they’ve paid us, we’ve settled at least one debt.”

The problem, Harnick says, is that although debt settlement companies don’t get paid until they settle at least one debt, the debts they handle are often a lot larger than they started out.

Debt Settlement’s First Dirty Secret: Most Debts Don’t Get Settled

debt settlement most debt growsThough debt settlement companies claim otherwise, their model has at least one fundamental flaw. Most people who try to settle their debts with debt settlement companies end up owing more money after the process is complete.

“You cannot enroll in most debt settlement programs unless you agree to default on all your debts,” says Harnick. “You must default on them all to enroll in the program. The debt settlement companies say, with some justification, that until you default, it’s very hard to get your creditors to be willing to settle.”

Most debt settlement companies deal with credit card debt. The debt settlement companies claim that for the most part, your credit card company isn’t even going to negotiate until they’ve charged off the debt. The result of this is that if they settle a debt, that’s great. Depending on what they settle it for, it’s fine. But meanwhile, all the debts that they haven’t settled are growing because the client is now incurring not just the normal interest but default rate interest plus fees and penalties.

“So all that would not matter much if the debt settlement company managed to settle all the debt,” says Harnick, “because then you’d say, well, who cares how much the debts grow if they’re settled? You know, if you settle them for a fraction of how much I owed initially, then I’m ahead. And I would agree with them completely on that. The problem is that historically very, very few people have managed to have all their debts settled.”

debt settlement trapHere’s Why Most Debts Don’t Get Settled

Some credit card companies simply refuse to deal with debt settlement companies. There are a lot of Credit card companies that understandably resent the debt settlement model. Because of that, they won’t settle. They’d rather be able to squeeze more out of the debtor and they certainly think any money that’s being paid ought to be paid to them, and not to a debt settlement company.

Also see: 8 Big Ways to Pay off Student Loan Debt

Debt Settlement’s Second Dirty Secret: Accretion

debt settlement accretionThe debt settlement industry issued a study a few years ago that they claim proves that now that the FTC rule is in place, debt settlement customers are doing just fine.

“But they refused to take account of what they call debt accretion,” says Harnick. “That’s the amount by which the unsettled debts are growing. They also refused to say what percentage of debts people had settled. The third thing they did was, let’s say you enrolled in a debt settlement program with five debts. They would say, I settled this one debt and I saved you 50%. Well, 50% of what? Most people want to know they cut their original debt in half. No, that’s not what they meant. They meant 50% of the amount that debt had grown to by the time it was settled.”

To see the Center for Responsible Lending’s analysis of the AFCC report, click here.

What Debt Settlement Companies Won’t Tell You

debt settlement failThe Center for Responsible Lending (CRL) worked to create estimates of how much debt actually gets settled by debt settlement companies. They worked with the industry to make sure the industry got a fair shake.

The first thing the CRL did was say, “You need to show what percentage of people settled all their debts or settled half their debts or two thirds, just so we can get a snapshot of how people are ending up.”

“At the time,” says Harnick, “the companies in the debt settlement industry said, well, we can’t do it because the FTC rule only took effect at the end of 2010. And so here it is 2013 and it typically takes 3 to 4 years for people to complete the program, so we would need to wait a while to see how things play out. But it’s now 2015 and they still haven’t released that data. I’m pretty confident as to why.”

The Truth About Debt Settlement: You’d Have to Settle 66% to 80% of Your Debt Just to Break Even

debt settlement break evenCertain state attorney general offices require debt settlement companies to release exact data on how much debt got settled, how much debt grew, and how many debts were unable to be settled. Using that data, the CRL was able to estimate roughly how much debts grew on average. Using very conservative estimates, they found that a person would have to settle 66% of their debt in order to do slightly better than breaking even.”

The industry has never publicly released what percentage of people accomplish that 66% benchmark. According to Harnick, taking debt collection fees into account as well as taxes owed on any debt forgiven, you’d have to settle 80% of your debt to come out modestly ahead.

Also see: 6 Surprising Ways to Hack Your Credit Score

Even When You Do Reach a Debt Settlement, You Owe Taxes on It

Someone who gets $10,000 of debt settled has to pay taxes on that amount as if it were $10,000 of additional income. This doesn’t apply to everyone. Debts settlements less than $600 aren’t taxed as income. Further, anyone who can demonstrate that they’re insolvent won’t owe taxes on a debt settlement.

debt settlement taxes

IRS form 1099-C for taxes on cancellation of debt.

“However,” Harnick says, “the person would have to be savvy enough to use an accountant and to have the accountant fill out the paperwork to establish that the person was insolvent.”

In fairness to the debt settlement industry, when the CRL did their initial calculation, they didn’t factor in taxes or fees. However, there’s no doubt that for a proportion of people those fees and taxes are a factor, either because they’re not technically insolvent or because they don’t know what to do about it if they are.

Debt Settlement Would Be Great if it Worked

debt settlement doesnt workIt would be great if there was somebody negotiating to reduce the debt load of struggling consumers. The problem is that debt settlement companies are sort of promising an outcome from a third party (credit card companies and other creditors) without having an upfront agreement with the third party. So if a credit card company doesn’t want to settle or doesn’t want to settle at enough of a discount to offset the amount the debt has grown by, plus taxes and fees, then the person in debt just can’t get ahead.

“That’s been the experience historically of the overwhelming amount of people and I suspect more than half the people currently,” says Harnick.

Debt Settlement Just Doesn’t Work

debt settlement is a lieIn the past, the AFCC has claimed that a third of their clients completed the program. According to Harnick, most attorneys general found that it was far lower than that.

“Like under 10%,” says Harnick.

But even if you assume a third of all debt settlement customers completed the program, that means two thirds didn’t. That would mean fully 66% of all debt settlement customers walk away with 70% of their debt unsettled.

“That’s huge,” says Harnick. “That’s the vast majority of people. Now what they say is, yeah, but look at the alternative. The alternative is Chapter 13 bankruptcy, where the person is making a payout on a plan over five years. With Chapter 13 bankruptcy, the completion rate is only about the same. But what they don’t mention is, chapter 7 bankruptcy has a completion rate of something like 97%.”

Also see: What Is a Good Credit Score?

Non Profit Credit Counselors: A Better Path to Debt Freedom

debt collectors nfccWhile Debt Settlement companies are in business to make a profit off your debt, non-profit credit counselors are there to help. While most credit card companies refuse to make deals with debt settlement companies, credit counselors can often reach agreements in advance with creditors. A non profit credit counselor can help you create a plan to become debt free.

To find a non profit credit counselor, do a search on the National Foundation for Credit Counselors website by clicking here.