Why You Lose With Debt Settlement Companies

The rise of debt settlement companies (DSCs) has piqued the curiosity of many Americans who struggle to pay their bills. These companies promise immediate results and a debt-free life while downplaying or even leaving out the significant consequences of using their services.

If a debt-settlement option seems too good to be true, then it probably is. The Federal Trade Commission (FTC) and The Consumer Financial Protection Bureau (CFPB) have both issued statements warning consumers against DSCs. The Consumer Financial Protection Bureau has even taken legal action against some of these misleading companies.

If you’re thinking about working with a debt settlement company, keep reading. When you learn how these companies take advantage of people, you can prevent yourself and your family from falling for their schemes.

How Do Debt Settlement Companies Operate?

When you want to consolidate your debt with a DSC, you will first talk to a representative on the phone to explain exactly how much debt you are in, how many creditors you owe and how much you are currently paying off.

The promise that these DSCs sell is they will collect a certain amount of money from you, then negotiate the balance with your creditor to pay a lower amount than the amount owed.

However, this isn’t the always what happens. Many creditors don’t work with DSCs and will reject the proposal. That leaves you to negotiate with your creditors in the end, and the DSC will still demand a hefty fee for its services.

The first thing the DSC will do is ask you to cease contact with your creditors.  By doing so, you may lose an opportunity to work with your creditors to find a more suitable solution.

The DSC will, then, demand that you cease paying your creditors and instead will ask that you make monthly deposits into a DSC bank account, while your actual bills fall past due. The FTC says that some people spend up to 36 months depositing money into one of these accounts.

Despite the promises of the DSC, many people find themselves unable to make the monthly payments and end up dropping out of the program, leaving them with more debt than when they started, including what they owe the DSC.

Even if you are able to pay off their debt over the course of the agreement with a DSC, you typically are left with terrible credit for not paying your bills for several months.

DSC Example: The CFPB Sues Freedom Debt Relief

The Consumer Financial Protection Bureau is taking steps against misleading debt settlement companies to prevent Americans from falling for their scams. In a lawsuit filed against Freedom Debt Relief (the largest debt-settlement provider in the country), the CFPB explains how the company took advantage of people struggling with their finances.

A few of the accusations include:

  • Charging customers without actually providing debt collection services
  • Making customers negotiate their own settlements
  • Misleading customers about their fees and the scope of their services
  • Failing to inform them of their rights to the money they deposited in the savings accounts

The suit alleges that Freedom Debt Relief charged customers between 18 and 25 percent of the total amount they owed when they first started working the with the company as part of their service fees. This means customers who approached the company with $50,000 in debt would end up paying an additional $12,500 for the work. On top of that, the suit alleges that customers ended up doing most of the work themselves (leaving them to wonder what the hefty fee was actually for) while they ruined their credit scores at the behest of exploitive financial advice.

While Freedom Debt Relief is accused of requiring customers to contact financial institutions themselves to negotiate debt payments, other DSCs take the opposite tactic. They require customers to cut off all contact with their creditors and solely communicate with the debt settlement agency. This allows the DSC to control the situation and prevents credit companies and customers from reaching debt agreements on their own for free.

DSCs Can Also Impact Your Tax Refund

Even if you walk away relatively unscathed from working with a debt settlement company, you could face another blow months later when it’s time to file your taxes.

Many people who cancel their debts receive 1099-C Cancellation of Debt tax notices from creditors. Forgiven or canceled debt is considered taxable income under current US law, and creditors are required to report the debt forgiveness to the government. These forms are sent to more than four million Americans annually who have had their debt canceled or forgiven.

If you agree to pay at least $600 less than the money you owe, then you are required to file a 1099-C form. For example, if you were $50,000 in debt and only had to pay $30,000, then the $20,000 that was canceled is considered taxable income. However, consumers are strongly encouraged to consult with a tax professional regarding their unique circumstances.

All in all, the cost of working with a debt settlement company adds up. First, you’re expected to pay thousands of dollars in fees to cover the work of the DSC, and then you may have to pay hundreds or thousands more in taxes to the government. If you were already struggling to pay off your debt, then these expenses could keep you in the red.

There Are Better Options Than Working With DSCs

If you’re struggling with debt, you don’t have to work with debt settlement companies. The FTC reminds consumers that contacting their credit companies is absolutely free. Companies are often willing to work through a payment plan even if you can’t pay your debt for a few months.

When you talk with your creditors, mention hardships that are preventing you from paying off your debt. Depending on the type of loan, you may be able to push out your due date or quality for a temporary payment reduction.  If your hardship is more permanent, most creditors will entertain offers to settle the debt directly.

Additionally, most creditors will also accept plans from credit counselors and will work with you to find an affordable payment that continues to pay down the debt.

Identifying a Scam Can Prevent Further Financial Mistakes

You don’t have to be a financial professional to spot scams that could destroy your credit and leave you in thousands of dollars in debt without providing services.

By avoiding debt settlement companies and looking for transparent ways to manage your debt, you can take steps to pay off what you owe and start repairing your credit.