Debt Settlement Providers: Tough Questions, and What to Watch For

Updated February 19th, 2020

If you’re in debt and it seems like there’s no solution in sight, you might be intrigued to hear a radio announcer tease you with “the secret credit card companies don’t want you to know” or see an online advertisement suggesting that you can cut your debt by up to 50% without bankruptcy.

The temptation is understandable, but debt settlement companies have a few secrets of their own. Educating yourself and asking tough questions of anyone who offers you debt solutions is critical, and never more so than when you’re considering debt settlement. 

Key Questions for Debt Settlement Providers

Here are some of the most important questions to ask before entering into a debt settlement plan, along with some information about what you should expect. 

1. How will debt settlement impact my credit history and my credit scores? 

A debt settlement provider won’t be able to provide a specific answer to this question, since they can’t anticipate what actions your creditors will take while you’re participating in the plan. But, you should know that debt settlement can have a very negative impact on your credit, and you should be wary of any provider that tells you otherwise or hedges when asked this question.

When you enter into a debt settlement program, you typically begin making payments into your settlement fund--held and administered by the company--and stop making payments to your creditors. It can be months before you settle your first debt and some may take years. But, during that time, you have no agreement with the creditor. That means those missed payments will generally be reported to the three major credit bureaus. 

2. Will I face other collection action while I’m enrolled in the plan? 

Again, the debt settlement company can’t say for sure what collection action your creditors will or won’t take. The important thing to know is that debt settlement doesn’t stop creditors from calling, sending collection letters, turning over your account to a collection agency, filing a lawsuit, garnishing your wages, or attaching your bank accounts to satisfy a judgment. 

Most people who file bankruptcy have the benefit of the automatic stay, a court order that prevents most collection action for as long as it is in effect. Those in debt settlement programs have no such protection. From the creditor’s perspective, the only thing that has changed is that the debtor has stopped making payments. 

3. Do creditors have to cooperate with debt settlement? 

There’s a clear, short answer to this one, and it’s “No.” Each creditor or debt buyer decides whether or not to work with a debt settlement company, and what terms it will agree to. Some have policies against working with debt settlement companies at all, while others routinely work with certain companies. Some, may make the determination on a case-by-case basis. 

The debt settlement company should be able to tell you which creditors refuse to work with them at all, but that’s no guarantee that the rest of your creditors will, or that they’ll be able to reach a settlement that works for you.

4. Have you faced class action lawsuits or regulatory actions? 

Regardless of what a debt settlement company tells you, you’ll want to do your own homework on this issue. In addition to the problems inherent in the debt settlement model, the industry has been home to quite a few shady operations. In fact, it’s so common for various types of debt relief companies to take advantage of those in tough financial situations that the Federal Trade Commission (FTC) publishes a list of companies that have been banned from providing debt relief services. 

The Consumer Financial Protection Bureau (CFPB) settled a lawsuit against Freedom Debt Relief, the nation’s largest debt settlement company, for $25 million. Freedom didn’t admit to any wrongdoing, but the CFPB’s complaint alleged that Freedom had led consumers to believe that all of their debts could be negotiated through the plan, though the company knew that some large creditors had established policies against negotiating with debt settlement companies. Freedom was also accused of telling consumers to negotiate directly with those creditors that wouldn’t work with the company without disclosing their enrollment in the program. If the negotiation was successful, the complaint said, the debt settlement company would collect fees on the settlement, though it had not handled the negotiation.

5. What are the tax ramifications of debt settlement? 

Few people think to ask this question unless they’ve put in some research, but it’s a critical one. While debt settlement providers may make it sound like you’ll simply get a significant percentage of your debt slashed off in the settlement, there are other costs associated with the process. One, obviously, is the debt settlement company’s fees. Another often comes as a shock when tax time rolls around. 

When debt is written off, the IRS typically treats that erasure of debt as income. In one way, that makes sense: if you’ve been relieved of the obligation to pay $30,000 in debt, you’ve effectively gained $30,000. The problem, of course, is that you haven’t actually received that money, and may not have funds to cover the tax debt created by the settlement.

The IRS excludes debts canceled in bankruptcy from taxable income, and even provides a quick and easy form to complete if a creditor whose debt was fully or partly discharged in bankruptcy sends you a 1099-C. But, there’s no such exception for debts settled through a debt settlement company.

Educate Yourself about Your Debt Resolution Options

The bottom line is that there are many possible downsides to debt settlement, and the only way to find the right solution for you is to thoroughly educate yourself about the options. A glib promise like, “pay only a fraction of your debts!” may look like a lifeline, but in some cases may turn into an anchor weighing you down. 

One way to learn more about your options is to schedule a free consultation with one of our experienced bankruptcy attorneys in Alabama, Mississippi or Tennessee.

For more information, California attorney Gary Fraley touches on these tips, and some others worth considering in the video below: