When your debt is starting to mount and you feel that you need to confront the creditors, (or they are hounding you like wild wolves) you may be thinking about debt settlement companies to assist you. There is a lot of advertising out there and it is very alluring. While these plans may sometimes work, my general experience as a bankruptcy attorney--and that of the vast majority of the 4,500 members of the National Association of Consumer Bankruptcy Attorneys--NCABA) is the plans do not work very well at all. By the numbers, they are also a scam. Here are some reasons why:
- These companies generally negotiate the interest rate at the beginning which looks good. They collect your monthly payments, put them in escrow, subtract their fees, which are relatively big, and when you reach a certain amount they approach a company on your list and offer a settlement amount. Pending the settlement there accrues additional interest, late fees and over-limit fees that can eat up much of the "savings" which were the goal of these negotiations. (See example below.) Th interest rate sometimes reverts back or is even increased because it is taking so long to settle
- Many large credit companies and debt collectors refuse to negotiate at all with debt settlement companies.
- The settlement company does not do anything that you couldn't do for yourself. If you wait long enough, the debt buyers will offer you the same terms--sometimes better.
- The overwhelming majority of folks never stick with the payments for long enough, which means that the rather large fees of the settlement agent are earned for doing nothing. You wind up worse off then where you started.
- Creditors trash the client's credit rating and often sue; none of this is stopped during the payment period.
- Your damaged credit rating is not healed from any of this--even after you settle.
- Debt settlement will hurt your credit longer than bankruptcy, since the debts continue to be reported as bad debts for longer period of time.
- For all amounts settled, a 1099-C is issued to you and the IRS for the forgiven debt. Taxes must be paid on this amount--which comes usually as a shock in the next tax year.
- Debt settlement companies do not underscore the 1099 issue at all and many do not even tell you of the debt forgiveness taxes you will be responsible to pay.
Let's give an example by doing the math:
You have credit card account with a balance of $10,000. The debt settlement company settles it for $5,000 after 18 months. Here's why this is a bad deal for you:
- The credit card balance is significantly higher when you finally settled. During the 18 months necessary to build up the lump sum settlement, there would be $720 in late fees (18 @ $40), $720 in over-limit fees (18 @ $40), and interest of $4,500 (30% APR on $10,000 for 18 months [not including compounding]). So at the end of 18 months, instead of a $10,000 credit card balance, the balance is $15,940.00. In addition, collection costs are added, typically 15%, further increasing the balance to $17,440.
- Now, the difference between the balance when settled--$17,440 and the $5,000 paid is $12,440 forgiven debt. As a result you owe an additional $4,665 in taxes on the settlement (assuming you are single at 25% federal and 12.5% state tax rate).
- If your settlement plan is successful, you would emerge from your program solvent, and would thereby be ineligible for Form 982 relief. (This is federal tax form to try to prove to the IRS that you were insolvent at the time of the debt forgiveness and should not owe taxes on the amount). By paying you set yourself up to be ineligible.
- You also paid $1,866 in fees @ 15% to the debt settlement company (which is low) based on a balance of $17,440 and a settlement of $5,000.
So, when adding in the actual cost of the settlement ($5,000), as a result of using the debt settlement service, you settled a $10,000 claim by paying $11,531, and have to put up with 18 months of nasty calls and letters, and possibly lawsuits, judgments and garnishments.
If this is not a scam, then why are attorney generals all over the US investigating these companies, trying to stop these results?
Oh, by the way, then there is "Zombie debt" in which the creditor who settled with the debt settlement company, sells your account to a debt collector for pennies on the dollar. This may not be proper due to the 1099-C issue but it is still happening. The new owner of the debt argues that the debt is actually still owed pursuant to the contract with the creditor. The debt collector renames it, gives it new account numbers, posts it to your credit report after some while and then starts trying to collect on it.
When you finally figure out that it was the settled debt of 3 or 5 years ago, and bring it up with the debt collector, they laugh at you, and claim you still owe on the original debt contract and must pay up.... Phase two of harassment has begun and intensifies. You will need to hire a lawyer. More fees. The collector's argument is that no new consideration was offered to create a new contract and no intervening court dispute is of record, so you are back to the beginning. Now depending on how much time has passed, the $12,440 forgiven is much, much higher! This is a nightmare and frankly litigation time. It is no fun.
Whereas, if you filed bankruptcy to deal with this debt, it would be liquidated, no 1099-C would effect you as section 108 of the Internal Revenue Code has forgiven the taxes, your credit rating started to heal, it cost much less, and it was less stressful. Even if some zombie debt issue comes up later on your bankruptcy case can be re-opened to deal with a violation of the permanent injunction against collecting a discharged debt!
Creditor law and practice is massive and in the creditors' favor. The bankruptcy law is the one really powerful and effective way to respond--like the slingshot of David against Goliath. It works....
Iowa Bankruptcy Attorney Robert J. Liptak
Fairfield, Iowa
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