November 6

Debt Settlement vs. Bankruptcy

What is a debt settlement company?

You may have seen their ads on TV. The debt settlement company sales pitch is usually something along these lines: That for a fee they will use their established relationship with your creditors to reduce your debt by 50% or more. They often promise that your financial troubles will be over relatively quickly (i.e. within six to eight months) and that taking care of your debts through settlement will not hurt your credit report and will keep you out of bankruptcy. Some also offer that they can prevent lawsuits from your creditors.

Dealing with debt settlement companies can be a risky proposition

If you have looked for information about debt settlement companies on the internet you might have come across the Consumer Financial Protection Bureau’s (CFPB) web site. The CFPB is an independent government agency that was created in 2010 for the purpose of overseeing federal financial laws that protect consumers. According to the White House, the purpose behind the agency is to educate consumers about financial products, enforce federal consumer protection laws, and monitor and research consumer behavior, financial markets and institutions. According to a January 4, 2012 post by White House author, Megan Slack, the research the CFPB does gives them “more information about hazards consumers encounter when dealing with various companies and entities . . .”

Given that the CFPB is a government watchdog with the mission of protecting United States consumers from hazardous financial products, they are good source of reliable, independent and trustworthy information about dangerous financial products such as debt settlement services. The CFPB, which is well familiar with debt settlement companies, warns against their use. In a February 15, 2017 post titled “What are debt settlement/debt relief services and should I use them?” the CFPB definitively states that “Dealing with debt settlement companies can be risky.”

The CFPB then provides the following: “Warning:  Debt settlement may well leave you deeper in debt that you were when you started.  Most debt settlement companies will ask you to stop paying your debts in order to get creditors to negotiate and collect funds for a settlement. . . .”

Some debt settlement companies promise more than they can deliver. Some of your creditors may also refuse to work with the debt settlement company you choose. In many cases the debt settlement company will be unable to settle all of your debts.

Let’s take a look at how debt settlement companies operate

A debt settlement company typically offers to negotiate a settlement of your debt for an amount less than is currently owed. Typically this service is only offered for unsecured debts such as credit card debt or medical bills. Debt settlement companies typically do not offer to work with secured creditors like your mortgage holder or a creditor holding a lien on your car. Most debt settlement companies offer their advertised services for a fee. “[D]ebt settlement companies often charge expensive fees,” warns the CFPB.

Avoid Bankruptcy?

Many debt settlement companies advertise that they can solve your debt problems and help you to avoid bankruptcy. They play to many misconceptions about bankruptcy such as the fear of ruining credit or the fear of losing everything. The reality is that the debt settlement process can hurt your credit rating worse than filing for bankruptcy protection can. This is because of the way the debt settlement process typically works.

The debt settlement process

Debt settlement companies typically encourage you to stop paying your credit cards to save up enough money to pay the debt after it goes into default. When you do this, a chain of events starts into motion, first your credit report begins to show late payments and later it shows defaults on the debts. Even if the debt is settled the late payments and the default remain on your credit report for seven years.

With defaults comes the typical assortment of late fees and penalty interest. Fees for exceeding your credit limit may also be triggered. In this regard, the CFPB warns that “[u]nless the debt settlement company settles all or most of your debts, the built up penalty and fees on the unsettled debts may wipe out any savings the debt settlement company achieves on the debts it settles.” You may be thinking, well they said they would probably be able to settle all of my debts and so I won’t have this problem. The odds of this happening are not in your favor. An October 15, 2009 report on debt management activity by the Colorado Attorney General showed that fewer than 10% of enrollees in debt settlement completed the programs over the average contract term which was 32 months. Note that 32 months is close to three years, much longer than the “quick” settlement process that you may have been promised.

If they have not already done so, a creditor dealing with a default will usually begin to step up collection efforts, including filing lawsuits.  At this point you may learn that debt settlement companies cannot actually protect you from lawsuits filed by your creditors.  Creditors are under absolutely no obligation to work with a debt settlement company.   The main option that the settlement company have available at this point is to try to settle the debt.  Importantly, however, is the fact that the debt settlement company has no way to guarantee that a creditor will accept a settlement offer.  While the settlement company tries to negotiate, collection activities such as lawsuits do not stop.  This likely leaves you in a position where you are negotiating with the creditor from a position of weakness rather than strength. Compare this to a bankruptcy proceeding where creditors are required by federal law to stop their collection actions by law and participate in the bankruptcy.  Debts are dealt with in an orderly way, pursuant to federal bankruptcy law.

Another downside to debt settlement is that consumers are often still left with a lot of debt and the burden of dealing with the remaining debt.  Bankruptcy attorneys can testify to the fact that the financial problems of many debt settlement clients continue and they end up filing for bankruptcy protection anyway, but only after wasting valuable money and resources on a failed settlement process.  Bankruptcy, on the other hand, affirmatively and legally puts an end to debt issues you are facing.

Something debt settlement companies don’t like to advertise – Tax consequences for you

Let’s say you are able to settle some or all of your debts.  After the year end rolls around, you may get another surprise that wasn’t boldly advertised – additional income reported to the IRS in your name.  The amount of a debt that is forgiven or settled is generally taxable as income to you.  Most creditors will send form 1099-C at the end of the year showing the amounts settled as taxable income received by you.  Comparatively, debt discharged in bankruptcy typically does not give rise to taxable income.

Debt Settlement Scams

As if that weren’t enough, we now get to the dishonest operators – the bad apples.  The Federal Trade Commission (FTC) warns that “some companies offering debt settlement programs may engage in deception and fail to deliver on the promises they make. . .”  If you want to go the debt settlement route, the FTC recommends checking out the company you are looking at with your state Attorney General and your local consumer protection agency.

Bankruptcy is not for everyone

To be clear, bankruptcy is not for everyone.  You still have to decide whether bankruptcy is the right option for you.  Often times, however, bankruptcy can be the right initial option that is overlooked or put off on hopes that options such as debt settlement may work out. When compared with debt settlement bankruptcy can often achieve much more than debt settlement companies can. Rather than going forward on a hope and a prayer, bankruptcy can address debts in a legally certain way and typically on better terms than debt settlement companies.  Debt settlement companies on the other hand, may even leave you further in the hole than before you started.

With debt settlement, control remains largely within the hands of your creditors.  As was pointed out, creditors have absolutely no obligation to negotiate with a debt settlement company and can continue to move forward with lawsuits against you all while you try to negotiate.  This can leave you vulnerable and may leave you negotiating from a position of weakness rather than strength.  Bankruptcy, however, removes creditors from this powerful position.  Upon filing bankruptcy, creditors become subject to the rules and orders of the bankruptcy court.  Collection actions are stayed and your debts are worked through in an orderly manner.

Debt settlement companies play upon fears that bankruptcy will ruin your credit, but the reality is that the debt settlement often ends up being much more harmful to your credit than bankruptcy.

The debt settlement industry is fraught with dishonest operators.   While there are decent, legitimate operators out there, you have to be especially diligent to determine who they are at risk of losing your money to a fraudster.  There are bad lawyers out there too, but most of them are quickly discovered and dealt with by the state Bar Association which regulates and actively monitors its membership. The bankruptcy proceeding itself is overseen and regulated by the federal judiciary and the safeguards that they have in place.

If you are looking at your various options for dealing with your debts, I can answer questions you may have about whether bankruptcy may be a good option for you. To schedule an initial free and confidential consultation to discuss your particular situation call 601-853-9966.

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