Debt Consolidation and Debt Settlement Companies

Barely a week goes by when I’m not asked by a potential client about using a debt consolidation company or debt settlement company. Also barely a week goes by when a potential client comes to the office with a story of already having tried the debt consolidation company with bad results. In general, we advise against using these companies. Read on to understand why.

There are no shortage of advertisements on late night television touting the benefits of these companies. Let’s start by examining what a debt consolidation or debt settlement company does. These companies promise to negotiate with your creditors to obtain a lower payment. When you owe a debt, often your creditor will “settle” for a lump sum payment in the neighborhood of 50% of the total owed. The debt consolidation companies know and use this fact. Typically you pay monthly payments to the debt consolidation company. They deduct their fee from your payment, usually 15% or so of your payment with the remainder of your payment put into a form of savings account. Once your “savings account” has reached a sufficient balance, they will contact your creditor and attempt to settle.

Let’s look at a simple example to see how it would work. Let’s say you owe 5 credit card companies $5,000 each for a total of $25,000. You enter an agreement with a debt consolidation company to pay them $750 per month to make this go away. Each month, the debt consolidation company will take your $750 payment, deduct their $112.50 fee, and “deposit” your $637.50 into your “savings” account. After paying this for 20 months, you will have $12,750 in your “savings” account. With this money, and after the 20 months, the debt consolidator will contact each of the 5 credit card companies and offer to settle your account for $2,550.00. All good so far.

Let’s look at how much you have paid the company for their work. Over the 20 months you will have paid $2,250.00. Still not worried? Read on.

During that 20 months, interest on that $25,000 has continued to accumulate. On a typical 19% interest credit card, this will be over $8,000 more in interest. That means the credit card company may not be ready to play ball yet. In addition, during that 20 months, NO payment is being made on your credit cards. The credit card companies are continuing to report late and past due payments on your credit report and your credit score plummets. Another thing these companies seem to fail to tell their clients, the credit card companies are free to file a lawsuit, and often do, during these 20 months. I had a client recently who had paid in for 9 months only to be sued. When she contacted the debt settlement company, their reply was, “we’ll reduce your payments since we won’t be able to negotiate with that creditor”. Not a good solution.

Another little disclosed fact, when you settle a debt for less than the full amount, the creditor often reports the amount written off as income to the IRS. In our above example, that will be extra income of $12,250 you will have to pay income tax on. There goes your tax refund.

Now let’s compare how the same scenario might work in bankruptcy. Client pays all costs and attorney’s fees of around $1500 (this can vary by case specifics). Their bankruptcy attorney prepares and files a Chapter 7 bankruptcy. Upon filing the case, the creditors MUST stop all collection activity. That means no more phone calls, no lawsuits filed, and no judgments. The $25,000 is discharged in the bankruptcy a few months later. In bankruptcy, the discharged debt can’t be reported to the IRS as income so that tax refund is safe. In all, this hypothetical client would save several thousand dollars, complete the process a year and a half quicker.

Before working with a debt settlement or debt consolidation company, come in for a NO COST, NO OBLIGATION consultation with one of our Nashville Bankruptcy lawyers. During this meeting you can learn if debt settlement is a viable option for you or if bankruptcy is a better route.