Creditors will usually only settle for less than owed when the debtor is under serious financial strain because if the debtor chooses to file bankruptcy, then the creditor gets nothing. If no financial hardship is evident the creditor may choose to take legal action.

Premise

Consumers who use debt settlement are those who are experiencing legitimate financial hardships, cannot afford to repay their debts through debt management plans offered by consumer credit counseling agencies and who also want to avoid filing bankruptcy. For this reason, debt settlement falls between consumer credit counseling and bankruptcy.

Many consumers may be better off negotiating themselves with creditors to avoid all of the charges that debt settlement companies are charging. Before looking to a debt settlement company consumers may want to contact their creditors to arrange payment plans (which does not reduce the debt balance), since most creditors are willing to work with the consumer when their account is past due. Often consumers are too emotionally involved to negotiate the best debt account settlements possible and choosing to work with a reputable debt settlement professional is their best option.

Debt settlement programs are provided by third party debt resolution firms who set up payment plans, and then negotiate settlements on behalf of the consumer. Typically, debt settlement programs are able to lower monthly payment contributions to approximately half of the typical minimum monthly credit card payments, and get consumers debt free in a short period of time.

Brief history of debt settlement

With charge-offs (debts written-off by banks) increasing, banks established debt settlement departments staffed with personnel who were authorized to negotiate with defaulted cardholders to reduce the outstanding balances in hopes to recover funds that would otherwise be lost if the cardholder filed for Chapter 7 bankruptcy. The settlements ranged between 25% and 65% of the outstanding balance (Sworn Testimony of Dr. Robert Manning, author of Credit Card Nation).

In the late 1980's and early 1990's there were two companies (Berglas Hill & Ryan and Arbitronix Inc. that were in the forfront of third party debt settlement. However, the emphasis at that time was not on consumer debt, but commercial debt. While negotiation and debt settlement are not new and go back centuries, here for the first time in modern debt and credit history debtors had an option outside the law firm to level the playing field and have representation to take away the advantage held by Collection Agencies and Debt Collection law firms. Soon, the internet brought concept cloning and a plethera of commercial debt settlement companies emerged, some independent and some in groups under individual banners. A trade association for commercial debt settlement companies was formed but lasted but a few years to be replaced by what currently exists in the consumer debt field as set forth below.

What happened next: In the late 1990's and into the new millennium, consumer debt reached an apex and an all time high. Consumer Credit Counselers and similar non profit and for profit companies had been operating for some time, but not with a lot of press. Banks suddenly began to change the game and the key to debt counseling (reducing interest rates) was over. The alternative was another form of debt negotiation taiken from the commercial world. Negotiation of credit cards and other consumer debt became very hot with companies springing up to sell the concept of getting out of debt by third party negotiation and in doing so, saving money. However, these companies were new to the game and had no negotiation experience. It created havoc forcing the FTC to step in in several instances and shut some charleton companies down. Ever since, consumer debt settlement has been under the FTD microscope. As a result, ethical entrepreneurs from the commercial world began establishing companies to negotiate debt settlements with creditors on the debtors’ behalf and some very responsible commercial debt settlement companeis with reputations for excelence began to take on the consumer debt settlement marketing compannies and do the negotiations for them. These alliances saved the industry. Unlike the creditor supported consumer credit counseling industry, debt settlement companies are usually for-profit companies that charge fees for their debt settlement related services. Another stark difference is that debt settlement companies do not negotiate reduction in interest rates, distribute monthly payments to creditors or report enrollment to credit bureaus. Instead, debt settlement companies negotiate reduction of the outstanding balance of each debt in exchange for a lump-sum payoff or short-term installment payoff.

To support the debt settlement industry and develop standards and best practices, practitioners established the United States Organization for Bankruptcy Alternatives ( USOBA) in 2004. Formed in 2000, The International Association of Professional Debt Arbitrators (IAPDA provides industry training and certification of debt settlement practitioners, In 2005, a small group established The Association of Settlement Companies ( TASC) to fight “unfair and ambiguous debt management legislation” in Texas and broadened its focus to all fifty states after its successful Texas campaign. The Uniform Debt-Management Services Act (UDMSA) is proposed legislation for adoption by all 50 States.

Debt settlement process

Once the creditor agrees to a settlement amount, payment is arranged and the account is considered settled-in-full (as opposed to paid-in-full). The debtor continues saving up and setting aside funds into the settlement fund to accrue enough funds for negotiating a settlement for the next willing creditor. Essentially, the process is a cycle of saving up and setting aside money, negotiating a settlement and paying the settlement.

Debt settlement compared to debt management plans through CCC

In a DMP, the credit counseling agencies works to lower the interest rate on the credit card account in hopes of lowering the monthly payment and causing more funds to go towards paying off the principal instead of the interest charges. The result of this is faster payoff of enrolled debts, within 60 months. The payments for different debt accounts are consolidated into one payment to the credit counseling agency who then distributes the payment to each creditor based on a scheduled repayment plan. Debt management usually charges a set up fee and a small monthly fee, however most are non-profit companys. They send out proposals to all creditors to propose new payment arrangements.

In a debt settlement program, the debt settlement company negotiates with the creditor to lower the outstanding balance of the debt. Usually to enroll in a program with a debt settlement company there is a power of attorney that must be signed. This allows them to contact all of the cardholder's creditors. The debt settlement company does not negotiate lower interest rates and does not distribute monthly payments to creditors. The debt settlement company, usually through a third party payment processor, arranges for paying off debts once a reduced-balance settlement agreement is reached between the debtor and the creditor. The debt settlement client does make monthly deposits into their settlement fund, usually managed by an independent, third-party payment processor.

Most creditors will negotiate with a third party to settle consumers debt. Before deciding on a debt settlement or debt management plan one may want to contact each of the creditors to see what can be done. Some creditors offer hardship programs to the consumers in an effort to prevent the account from charging off.

Types of debts eligible for debt settlement

Debtor’s incentives

Creditor’s incentives

Common objections to debt settlement

Damages credit

Because payment history accounts for 35% of the FICO credit score calculation ([9] myFICO: What’s In Your Score), reports of non-payment to a debtor's credit file will lower the debtor’s credit score and reflect negatively on the debtor’s credit report. However 30% of one's FICO score is calculated by the amounts owed. So although debt settlement would hurt one's payment history, once the debt is eliminated it will improve the amounts owed portion of the FICO score (commonly called the debt-to-credit ratio) and also improve your debt-to-income ratio (used by future lenders).

The counter argument made by the debt settlement industry is that the good credit and the loose lending practices of the credit card industry enables consumers to accumulate an overwhelming amount of debt and all it takes is one financial hardship to interrupt the consumer’s ability to continue scheduled debt repayment. The other counter argument is that a consumer’s financial wellbeing is not always directly tied to their credit score and maintaining a credit score at the expense of basic needs is harmful to the consumer and the consumer’s family.

Increased collection calls

The counter argument made by the debt settlement industry is that many debtors are already being hounded by collection calls by the time they enroll in a debt settlement program. Many debt settlement companies offer assistance with alleviating collector calls and educate consumers about their rights as debtors as codified in the Fair Debt Collection Practices Act (FDCPA). Some companies actually change the phone number and address of their clients with the creditors to ensure that deal exclusively with the credit card companies.

While the FDCPA applied only to third-party debt collectors (not to creditors), some states passed legislation to supplement the FDCPA and to include creditors in their state consumer protection laws regarding debt collection.

Possibility of lawsuits

The counter argument made by the debt settlement industry is that while creditors have the right to take legal action to collect on a delinquent debt and such lawsuits are filed against debtors, such lawsuits are not as common as the threats of lawsuits. Debt collection lawsuits rarely make business sense because the costs, time and other resources involved in legal action usually outweigh the return on these investments, even after receiving a judgment. Often, legal threats are made by collectors in an effort to make the debtor give that creditor account a higher pay-off priority. The possibility increases with the amount of the debt

Tax consequences

The Internal Revenue Service considers $600 or more of forgiven debt as taxable income. The forgiving creditor must provide the taxpayer with a 1099-C tax form. This form will list the amount of forgiven debt and interest in Box 2. Taxpayers with portions of personal loans forgiven may not subtract the interest reported in Box 3 from the amount of reportable income on this form.

However, the IRS does not require taxpayers to report forgiven debt if the tax payer was insolvent at the time the creditor forgave the debt. Being insolvent means that the amount of a debtor’s debts are greater than his/her assets (how much money and property the debtor owns). However, the IRS adds that “you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent.” (IRS Publication 525)

For example, if a taxpayer is $10,000 in debt and owns $3,000 in assets, he/she cannot exclude more than $7,000 of forgiven debt from his/her income tax. Any forgiven debt over $7,000 that year must be reported as taxable income.