How Debt Settlement Companies Work

There appear to be significant variations within the industry, but debt settlement companies generally negotiate with a consumer's creditors to settle the debt for an amount that is discounted substantially from the balance due. The settlement company also negotiates a repayment schedule that is acceptable to the creditor.

In a typical program, consumers are often instructed to set up a separate bank account and make monthly payments to cover the settlement company's fees and also to build up cash that will later be used to pay the creditor. A number of settlement companies emphasize that the company does not have control over these funds, the account is controlled by the consumer, and that funds are disbursed only by the consumer. However, some settlement firms may structure their business in a way that enables them to draw funds directly from the account.

Many settlement companies collect the bulk of their fees early in the process, leaving only small amounts for paying creditors. They typically delay contacting the creditor until the fund has sufficient cash to begin negotiations on the account Able Debt Settlement Inc. told the FTC that the "average" debt settlement client has nearly $30,000 in unsecured debt spread across six creditors.

The settlement companies charge substantial fees, which are often collected up front before negotiations with creditors.

There is no standard fee model embraced by all debt settlement companies, but USOBA says that most settlement firms charge either a percentage of the consumer's total debt, or a percentage of the amount of debt saved through negotiations.

In the model where fees are based on the total amount of debt, it is not uncommon to see fees of between 13 percent and 20 percent assessed. Fees are higher, from 15 percent to 35 percent, when assessed only on the negotiated savings. Many settlement firms also charge monthly fees ranging from $19 to $85, according to USOBA.

Scott Johnson, CEO of US Debt Resolve, estimated in FTC testimony that 40 percent or more of the service fee is collected in the first three or four months and that the balance is usually collected within 12 months. But Johnson said some firms collect 65 percent of their fees in the first six months even though "the client won't have any results at that point. I do question that myself sometimes."

Travis Plunkett of CFA observed at the FTC workshop that on a $50,000 debt, fees in a typical front-loaded program could total $7,500, making it "very difficult" for most people to afford a program that hasn't delivered anything at that point. Plunkett urged a ban on up front fees, on the theory that the consumer needs to see some benefit before paying.

• Fees and disclosure: The fees are high and range widely from company to company. Perhaps as important, the degree and clarity of disclosure appears to vary as well. While there are a number of fee structures across the industry, a growing percentage of companies front-load the fees and collect the bulk of their money before rendering any service. Many consumers wind up abandoning the programs without any return on their investment and with higher debts than when they began.
  
  
• Misleading ads and transparency: Promotional materials tend to inflate the benefits and minimize the potential disadvantages of debt settlement. Ads often suggest greater debt reductions than possible and do not account for the impact of fees on the ultimate benefit to the consumer. While some settlement firms concede the potential drawbacks — including impact on credit scores or the creation of tax liabilities from debt forgiveness, others are less forthcoming.
  
  
• Tax liabilities: Many consumers probably do not realize that forgiven debts of $600 or more are considered taxable income by the IRS. In other words, if a debt is reduced from $20,000 to $10,000, the consumer may have to pay taxes on the $10,000 of cancelled debt. Along with fees, the additional tax payments reduce the consumers' savings from a negotiated settlement. It is not clear at what point debt settlement firms inform consumers of the tax liability from reducing their debts. Disclosure practices likely vary from company to company.
  
  
• Customer solicitation: Many settlement companies actively solicit customers, initiating contact through cold calls (sometimes from lead generation firms) and other aggressive outreach.
  
  
• Bad Advice, bad outcomes: Some industry materials say reliable settlement firms should never advise consumers to stop making payments, but it's reported that some settlement firms may tell clients exactly that. By stopping payments, consumers may increase their total debt because late fees and interest will likely continue to accrue at least until the account charges off or a negotiated settlement is reached — a process that can typically take many months. In addition, stopping payments to one creditor can trigger universal defaults that lead to higher interest rates on all of a consumer's accounts, which adds to total debt. Such action also can trigger legal action by creditors, including judgments or garnishment of wages for non-payment of debts. Some counter that legal action is rare and that creditors are more likely to sell the debt to debt buyers for pennies on the dollar.
  
  
• Misleading claims about credit counselors: In selling their own services, settlement firms sometimes provide consumers with erroneous or misleading information about credit counselors. For example, settlement firms provide misleading information about "fair share" to imply that counselors are beholden to creditors. They may misstate the length of a DMP program or minimize the benefits of credit counseling and the financial education programs provided by counselors. Further, they state that the cost of settlement is less than the cost of credit counseling, and that their successful completion rate is higher.

• Debt settlement companies charge high fees, and often collect a substantial portion of the fees at the beginning of the relationship before a consumer receives any benefits.
  
  
• If the settlement company cannot negotiate the promised reduction, or if the consumer has to leave the program early, all of the fees paid could be lost before the consumer realizes any benefit.
  
  
• Some settlement companies may make promises that they are unable to keep. These companies can't guarantee any savings at all, or even that all of your creditors will work with them.
  
  
• Because of settlement fees and potential tax liabilities, consumers may actually save much less than they expect. In some cases, consumers may save nothing at all.
  
  
• A consumer's debt may actually grow larger when they work with a debt settlement firm because negotiations between the settlement firm and creditors may not start for several months after the consumer has signed up. Creditors will generally continue to charge late fees and interest each month during that time.
  
  
• The consumer's credit report and score are likely to be negatively affected because the creditor does not receive payment on the account for months before a settlement agreement is negotiated.

Questions to Ask When Considering Debt Settlement