Is Debt Settlement a Scam?

Debt settlement programs promise to negotiate with creditors on your behalf to reduce your debt. Not all of these companies are bad - but, with these promises come numerous stories of scams and failed negotiations, leaving many to wonder: is debt settlement a scam?

What is Debt Settlement? 🏦

Debt settlement is a process in which a company negotiates with your creditors to allow you to pay a lump sum that's less than the total amount you owe. Typically, this process is used for unsecured debts, like credit card debt or medical bills. It often takes 1-3 years to go through the entire program and can save you a lot of money on your overall debt burden, but comes with drawbacks like a massive hit to your credit score and fees.

How Does it Work, Exactly?

Here’s the typical process for debt settlement:

Step 1: A debt settlement company will sign you up and “enroll” your debts, promising to negotiate with each of your creditors directly on your behalf to get you a lower debt amount.

Step 2: They will often charge a percentage of the total debt enrolled - around 15-25%. However, they do not charge this upfront, and it comes out of your normal monthly payments.

Step 3: This is important, so pay attention: They require you to stop making payments to your creditors in order to give them negotiating leverage - this part hits your credit score because it WILL show up as a delinquency.

Step 4: They set up an escrow account with them where you will make your payments. These payments will then be used to pay off your creditors once they’ve done the negotiating, and they’ll take their portion of the fees out of that payment

Step 5: The whole process can take 3-5 years, and your creditors can still bother and contact you as they’re trying to collect. Debt settlement companies do not guarantee that they’ll be able to negotiate all of your debts.

Step 6: You will likely need to pay federal taxes on the amount of debt forgiven

The Appeal of Debt Settlement 💸

The appeal of debt settlement lies in its promise to reduce the amount of debt owed, potentially saving individuals thousands of dollars and offering a faster route out of debt without going through the stigma of bankruptcy. For those struggling under the weight of substantial debt, this can seem like an ideal solution.

The Risks and Downsides 📉

Scams and Fraudulent Companies

The debt settlement industry has its share of scams. Fraudulent companies might take your money without any intention of negotiating with your creditor, or will make promises they can’t keep, so it’s crucial to research and select companies that are reputable and have a track record of successfully helping clients. Here are some larger companies who we find have a relatively good reputation:

  1. Achieve
  2. National Debt Relief
  3. Accredited Debt Relief

Fees and Costs

Even legitimate debt settlement companies charge fees for their services, often a percentage of the debt being settled. These fees can add up, sometimes offsetting the savings gained from the settlement itself – something to watch out for.

Impact on Credit Scores

Debt settlement will likely have a significant negative impact on your credit score. The first hit to your credit is going delinquent, while settling a debt for less than the full amount owed does show up on your credit report for up to 7 years. Now, a settled debt isn’t treated as poorly as a bankruptcy, but some lenders may deny you for this.

You may think that going with debt settlement will get your creditors to stop calling you to collect, but this isn’t necessarily the case! They may still chase you, regardless of whether you start working with a debt settlement company.

Tax Implications

The IRS may consider any forgiven debt as taxable income. This means you could owe taxes on the amount of debt that was forgiven, adding an additional cost to the settlement process. With bankruptcy on the other hand, debt forgiven is tax-free.

So, Is It a Scam? 🤔

While not all debt settlement companies are scams, the industry does contain elements that individuals should be wary of. The key is to approach debt settlement with a critical eye:

  • Research: Look for companies with positive reviews, accreditations (like from the American Fair Credit Council), and a history of success.
  • Transparency: Reputable companies will be clear about their fees, processes, and potential impacts on your credit.
  • Consider Alternatives: Before committing to debt settlement, make sure you explore your options such as debt consolidation, credit counseling, or even bankruptcy, depending on your situation.

Is It Right For Me? 🧠

Debt settlement can be a legitimate option for those facing insurmountable debt. Here are the situations in which debt settlement may be the correct option, and things to keep in mind:

  1. Can’t Handle Your Payments: If you have so much debt that you cannot afford to make your payments, you should consider either refinance or debt settlement.
  2. Credit Isn’t Great: We first suggest going the route of refinancing your debt (i.e. getting a new loan with easier payment terms and paying off your existing debt). However, if your credit isn’t good enough to refinance  and you are having trouble getting approved, debt settlement may be the next step.
  3. Still Need Access to Credit: Debt management programs/credit counseling will require you to close all of your credit cards and only rely on debit. While we recommend doing this regardless of whether it’s required, you may still need access to a line of credit and go with debt settlement instead.
  4. Should I do Bankruptcy? Bankruptcy will put a pause on all your collector calls and will remove the obligation to pay, at least in the meantime. However, there are public records attached and it will stay on your credit score - most lenders will not approve you for at least 3 years after the bankruptcy. The same can be said for debt settlement, however, so it may be the public stigma that drives you to want to negotiate things privately.

The Bottom Line.

Debt settlement presents a tempting promise to reduce debt quickly, but it's essential to approach it with caution. Remember, the goal is not just to reduce debt in the short term, but to build a foundation for long-term financial health and stability.

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