Unemployment. Bankruptcies. Foreclosures. Credit card debt. Job losses. The news is full of these stories almost every day. For many families, they aren’t just headlines; they are realities faced during an economic downturn.
Unfortunately, some people see today’s economic environment as a chance to make a profit at the expense of others who are suffering. Today’s families are bombarded with ways to get out of debt or get rich quick schemes, but few offer legitimate opportunities to improve family finances. While getting out of debt sounds great, most people are not aware of the pitfalls that come from using some of the available debt management services. Debt settlement, consolidation and counseling may all sound similar, but they are actually very different—with very different outcomes.
Debt settlement involves negotiating down the amount of debt a consumer owes. Debt consolidation is combining several loans or liabilities into one loan to reduce the monthly payment. Debt counseling is giving advice, usually for a fee, to individuals who are struggling with high levels of debt that generally results in a debt management plan to repay the debt.
Of the three, debt settlement companies pose the highest risk to a family’s finances. The Federal Trade Commission warns that fraudulent practices in the debt settlement industry are continuing to grow, costing families millions of dollars. With most debt settlement companies, individuals sign a contract agreeing to send the company a monthly payment for a set amount of time—generally three to five years. During that time, individuals are instructed to stop all payments to their creditors. Some companies send “cease and desist” letters to creditors, asking them to stop contacting families about their debt.
The settlement company collects its fees up front; most fees are several thousand dollars, including a fee to establish the account with the debt negotiator, a monthly service fee, and a final fee for the settlement payment. Once the fees are paid, the individual’s monthly payments to the company are accumulated in an account to pay creditors a future lump sum settlement. Most debt settlement companies will not start negotiating with creditors until a sufficient amount of money to pay the debt has been collected.
Following are several potential consequences of engaging a debt settlement service:
- Credit Damage. Because the settlement contract requires consumers to halt payments on their bills, late and missed payments are reported to credit bureaus and will stay on credit reports for seven years. Late and missed payments reduce credit scores, which results in higher payments, higher interest rates and reduced opportunities to get credit in the future. In addition, settlements are frequently reported to credit bureaus, telling potential creditors that the consumer did not repay the full debt and further reducing credit scores.
- Lawsuits. Having a debt settlement plan in place provides little, if any, protection against legal actions taken by creditors. Many creditors will sue consumers once they are contacted by the settlement company. In Oklahoma, creditors awarded a judgment against a consumer can garnish wages.
- Increased fees and interest. Because consumers stop paying their creditors when using a settlement program, creditors continue adding fees and interest to their accounts—causing the amount originally owed to double or even triple. With the additional interest and settlement fees, consumers may not save any money by using the service.
- Taxes. The IRS requires consumers to report any amount forgiven over $500 as taxable income.
- No guarantees. Just because consumers enter into a debt settlement contract does not guarantee that the creditor will accept a partial or settlement payment.
- Fraud potential. Some debt settlement companies make false claims or promises about what they can actually deliver on behalf of their customers. And in some cases, they have taken their customer’s money without performing any services on their behalf.
Families who need assistance in managing their debt should proceed with caution when seeking help. Major creditors are often willing to work out repayment plans when people really need to adjust their monthly obligations.
Generally, a non-profit debt counseling organization such as Consumer Credit Counseling Service (cccsok.org) is a better option to pursue, as they are local and take a more personal interest in serving their customers. Before entering into an assistance program, it is highly advisable to check out any company—whether non-profit or for-profit— with the Better Business Bureau or the State Attorney General’s office in the state where the firm is located.
Sue Lynn Sasser, PhD, is an associate professor of economics at the University of Central Oklahoma.