March 12, 2010

How Debt Settlement Works

There is no doubt that debtors are being bombarded with ads about debt settlement these days. I have been asked time and time again whether debt settlement is a good alternative to bankruptcy since presumably "it won't hurt my credit score as much".

Let me tell you how debt settlement works. Often, you are required to pay a sizeable sum up front as consideration for the debt settlement company handling your case. I have heard anywhere from $2,000 to $4,000 - the same cost as a bankruptcy! You are then required to make a monthly payment to the debt settlement company. In the mean time, you are defaulting on all your credit card debt. Once the debt settlement company has enough money in your account to offer a decent settlement to the credit card companies, they will call them up and negotiate a settlement since they now have funds to settle with. (Credit card companies are usually willing to settle for 50% or less if you are in default 4, 6, or 8 months, or more.) This is a strategy you can pursue all by yourself, without paying an agency. It's very simple: default; save up your money; negotiate a deal.

However, here are some things to consider:

(1) If you settle a debt outside of the bankruptcy context, you will have to pay taxes on the debt that was forgiven since it is considered "income". Alternatively, there are no tax consequences for debt forgiveness in bankruptcy.

(2) If you are going to be put on a payment plan, then you may as well do a Chapter 13 bankruptcy. Your plan payment in a Chapter 13 might be a lot lower!

(3) There will be consequences to your credit score no matter what you do. However, if you are starting with a fairly low score, you will see your score go up after a bankruptcy since you will become debt free.