How Do Debt Relief Companies Work?

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Debt relief companies, also known as debt settlement companies, promise help to people overwhelmed with debt, but their services can come at a steep cost—even beyond their significant fees.

What Do Debt Relief Companies Do?

Debt relief companies are for-profit businesses that charge you to negotiate with your creditors (the lenders you owe money) on your behalf. Their goal is to get creditors to accept less than the full amount you owe in exchange for settling the debt.

These companies often tout the possibility of drastically lowering your outstanding debt. That may sound great, but the reality is that debt relief companies' tactics with vendors can decimate your credit standing. Here are some hard realities to consider about the ways they work:

Prior to negotiating with your creditors, debt relief companies typically instruct you to stop making debt payments and instead make an agreed-upon monthly payment into a savings account they set up for you, often for a fee. After you've paid into the account for several months, the debt relief company approaches your creditors as your representative, essentially arguing that the creditors will be better off settling for partial repayment of your obligation than risking getting no payment at all. The implicit threat is that you're at the end of your financial rope, and that if you file for bankruptcy, lenders may be unable to collect anything you owe them.

If the debt settlement company is successful in its negotiations, it typically keeps 20% to 25% of your total debt as payment, and may charge you fees (for maintaining your savings account, for example) as it pays off the reduced debt on your behalf.

Why Is Debt Settlement Risky?

Debt settlement is risky for several reasons:

  • Debt settlement will cost you. Debt settlement can get expensive due to the fees that debt relief companies charge. In addition, if a settlement company succeeds in having your debt forgiven, the sum by which they reduce your debt may be treated as income for purposes of calculating your federal income tax. So depending on your earnings, tax bracket and available deductions, you could end up paying at least a chunk of the debt that was forgiven to the IRS.
  • Debt settlement damages your credit. During the negotiation process, if you've suspended payments on the advice of the debt settlement company, your missed payments will be recorded on your credit report. Because payment history is the biggest factor in credit score calculations, a series of missed payments will do serious damage to your credit. Missed payments also may be grounds for creditors to file debt collection lawsuits against you, or to sell your debt to collection agencies. Accounts sold to collections appear as negative entries on your credit report.
    In addition, if a debt relief company succeeds in getting creditors to reduce your obligations to them, renegotiated debts appear on your credit report as "settled accounts," and can remain on your credit report for up to seven years after you've paid them off. While less severe than bankruptcy or foreclosure, settled accounts are considered negative events in your credit history. Many lenders see them as grounds for caution when considering loan applications, and some lenders may decline applicants with settled accounts on their credit reports.
  • Debt settlement doesn't always work. There's no guarantee that a creditor will agree to reduce your payment obligation. If they refuse, you won't pay the settlement company any fees connected with that debt, but you'll have lost time, possibly incurred late payment penalties that increase your debt, and you may have had late or missed payments reported to the credit bureaus.

How Does Debt Settlement Affect Your Credit Scores?

Most of the potential negative credit report entries associated with debt settlement—settled accounts, late or missed payments, transfer of accounts to collections agencies—can have significant negative effects on your credit scores. The severity of their impact will depend on the nature and number of negative entries on your credit report, and how high your score was before the negative events appeared. The negative score impact will be greatest when the entries are new, and their effect on your credit score likely will diminish over the course of years, even though some of the entries will stay on your credit report as long as seven years.

Even worse, if debt settlement is unsuccessful, you may have no recourse but bankruptcy. That's probably the most severe negative event that can appear on a credit report, and depending on the type of bankruptcy settlement you file, it can remain on your credit report for seven or 10 years. Bankruptcy has a strong negative effect on credit scores. Like other negative credit events, a bankruptcy's impact on credit scores lessens over the span of years, but many lenders won't even consider lending to an individual with a bankruptcy on their credit report.

How Is Debt Relief Different From Debt Consolidation?

Debt relief companies sometimes arrange for you to make a single monthly payment to them, from which they make payments to creditors on your behalf (and extract fees in the process). Settlement companies sometimes call this process "debt consolidation," but that distorts the strict meaning—and benefit—of consolidating debts.

Debt consolidation—a strategy you can pursue without paying any third parties for assistance—involves taking out a loan at a relatively low interest rate and using the borrowed funds to pay off debts with high interest rates. This allows you to replace multiple monthly bills with one predictable monthly payment, which can simplify your budgeting and bill-paying routines, and can also save you money by reducing the amount of interest you pay over time.

Debt Settlement Alternatives

The alternatives to debt settlement will almost always save you money and help you avoid doing long-term damage to your credit as compared with turning to a debt relief company.

  • Debt consolidation loan: As noted above, debt consolidation loans shift high interest debt to lower interest debt. If you qualify, a debt consolidation loan can be a highly effective way to lower long-term borrowing costs and get high interest debt such as sizable credit card balances under control.
  • Balance transfer credit card: A potentially less expensive but somewhat riskier version of debt consolidation for those with good credit involves using a balance transfer credit card. This allows you to move debt from one or more high interest credit card accounts to a lower interest card account, such as one with a 0% introductory annual percentage rate (APR) on balance transfers. The fees and interest charges you could face if you don't pay off your balance transfer within the introductory period make this trickier than a simple debt consolidation loan, but it may be a good option for you.
  • Debt management programs: Debt management programs may sound a lot like debt relief companies, but their approach, cost and potential benefits differ greatly. Debt management programs are provided by nonprofit organizations dedicated to assisting individuals in financial trouble. Debt management organizations provide credit counselors who can help you organize your budget and take control of your debts. Credit counselors, such as those certified by the National Foundation for Credit Counseling, may work with your creditors to come up with interest rate reductions or extended repayment schedules that can help you pay your debts in full without compromising your credit.
    If your income and other financial circumstances make it infeasible to pay even renegotiated debts, certified credit counselors can steer you toward filing for bankruptcy and help guide you through the process.
  • Bankruptcy: If all other strategies fail, bankruptcy may be the only resort for overwhelming debts. Aside from the credit consequences—it can make it impossible for you to borrow money for years—bankruptcy can be emotionally difficult. It may be no worse than the stress of constant calls and letters from bill collectors, however, and it can allow for the eventual rebuilding of your credit and borrowing power.

The Bottom Line: Find a Better Option

Whether they call themselves debt relief companies, debt settlement companies or debt consolidation specialists, think twice before dealing with for-profit companies that promise big savings by renegotiating with debt with creditors. At best their services will come at considerable cost. They also put your credit at considerable risk and could still fail, leaving you with few alternatives besides bankruptcy. Instead, use one of the options above to help get your debts under control.