Debt Settlement
Debt settlement, also known as debt arbitration or debt negotiation, is an approach to debt reduction in which the debtor and creditor agree on a reduced balance that will be regarded as payment in full. As long as consumers continue to make minimum monthly payments, creditors will not negotiate a reduced balance. However, when payments stop, balances continue to grow because of late fees and ongoing interest. Consumers can arrange their own settlements by using advice found on web sites, hire a lawyer to act for them, or use debt settlement companies. Some settlement companies may charge a large fee up front; or take a monthly fee from customer bank accounts for their service, possibly reducing the incentive to settle with creditors quickly. One expert advises consumers to look for companies that charge only after a settlement is made, and charge about 20 percent of the amount by which the outstanding balance is reduced.
History
As a concept, lenders have been practicing debt settlement for thousands of years. However, the business of debt settlement became prominent in America during the late 1980s and early 1990s when bank deregulation, which loosened consumer lending practices, followed by an economic recession placed consumers in financial hardships.
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.
Alongside the unprecedented spike in personal debt loads, there has been another rather significant (even if criminally under reported) change – the 2005 passage of legislation that dramatically worsened the chances for average Americans to claim Chapter 7 bankruptcy protection. As things stand, should anyone filing for bankruptcy fail to meet the Internal Revenue Service regulated ‘means test’, they would instead be shelved into the Chapter 13 debt restructuring plan. Essentially, Chapter 13 bankruptcies simply tell borrowers that they must pay back some or all of their debts to all unsecured lenders. Repayments under Chapter 13 can range from 1% to 100% of the amounts owed to unsecured creditors, based on the ability of the debtor to pay. Repayment periods are 3 years (for those who earn below the median income) or 5 years (for those above), under court mandated budgets that follow IRS guidelines, and the penalties for failure are more severe.
How it works
Essentially, the debt settlement company negotiates on the borrowers’ behalf with creditors to reduce the overall debts in exchange for an agreement upon regular payments to be made. Only unsecured debts, such as medical bills and credit card debts can be handled, not student loans, auto financing or mortgages. For the debtor, this makes obvious sense – they avoid the stigma and intrusive court-mandated controls of bankruptcy while still lowering, sometimes by more than 50%, their debt balances. Whereas, for the creditor, they regain trust that the borrower intends to pay back what he can of the loans and not file bankruptcy (in which case, the creditor risks losing all monies owed).
There are obvious drawbacks – credit reports will show evidence of debt settlements and the associated FICO scores will be lowered as a result. However, if a “paid in full” letter is obtained from the creditor, the debtor’s credit report should show no sign of a debt settlement. There’s always the possibility of lawsuit whenever debts lay unpaid. Though few creditors wish to push borrowers toward bankruptcy – and the potential of governmental protection against all debts. In addition, the specific debts of the borrowers themselves affect the success of negotiations. Tax liens and domestic judgments, for reasons that should be clear, remain unaffected by attempts at settlement. Student loans, even those not federally subsidized, have been granted special powers by recent legislation to attach bank accounts without possibility of Chapter 7 bankruptcy protection. Also, some individual creditors, including Discover Card, for example, tend to have an aggressive resistance against negotiations.
Debt Settlement Companies
In order to work with a debt settlement company, a consumer needs lump sum cash (best scenario), or build up enough funds over pre-determined period of time. Once enough funds are built up the negotiation process can begin with each creditor individually. Accounts can be held by credit card companies or may be sold to collections agency for an average of a few cents. In which case debt can still be negotiated. The debt settlement company negotiates with the credit card companies for a percentage of the existing balances. The debt settlement companies typically have built up a relationship during their normal business practices with the credit card companies and can come to a settlement agreement quicker and at a more favorable rate than a debtor acting on their own. Once the consumer pays the agreed upon amount, some debt settlement companies take a percentage of the savings of the forgiven debt as the fee. With the current economic crisis, more and more credit card companies may be willing to settle existing credit card debts rather than add to their already large written off bad debt.
Because many debt settlement companies are for-profit and their employees are paid based on commissions, many frequently don’t even contact the debtor until the account has charged-off. In many states this practice is considered unethical.
Debt Negotiation Companies
Also a type of debt settlement firm, they offer a consumer a different way to get out of debt. These companies work with consumers who have no cash to make settlement offers with the credit card companies. Debt Negotiation companies set up “trust” for you – though they are not always a licensed bank. They collect a monthly fee to maintain the account, with the idea being that you are saving enough money to settle the accounts at a future date. A portion of the monthly payment towards the “savings account”, while a part of the payment is taken as a fee for the debt negotiation company. Unlike consumer credit counseling services, they do not pay your creditors each month, they put money into your “trust”. A legitimate company will use an FDIC insured bank for the trust account and give you access to it online 24 hours per day. They should also provide you with access to the negotiation correspondence with the credit companies.
The drop out rate of consumers from debt negotiation companies is high. [4] The debt negotiation companies do not handle calls from the credit card companies, nor the collection agencies. Credit card accounts typically go into collection after they are charged off, typically 180 days after the last payment on the account. The length of the program is often 3–5 years, and many consumers cannot keep up the payments for this period of time. Often, consumers wind up being sued or even more deeply in debt with added interest and fees piling up. This can be avoided by using companies with good standings and practices that protect consumers from these procedures.
Creditor’s incentives
The creditor’s primary incentive is to recover funds that would otherwise be lost if the debtor filed for bankruptcy. The other key incentive is that the creditor can often recover more funds than through other collection methods. Collection agencies and collection attorneys charge commissions as high as 40% on recovered funds. Bad debt purchasers buy portfolios of delinquent debts from creditors who give up on internal collection efforts and these bad debt purchasers pay between 1 and 12 cents on the dollar, depending on the age of the debt, with the oldest debts the cheapest.[6] Collection calls and lawsuits sometimes push debtors into bankruptcy, in which case the creditor often recovers no funds.
Common objections to settlement
There are five main objections to consumer debt settlement: damages credit, increased collection calls, possibility of lawsuits, tax consequences and the need to settle with all creditors.
1) Debtors can still be sued
A debt settlement company does not make monthly payments on the debtor’s accounts and they still remain in default. While the debts are still in default the creditor or its assignee can still file a lawsuit against a debtor. Most creditors and debt collectors want a lump sum payment to settle for less than the full debt. Although a debtor may make monthly payments to the debt settlement company, the amount is too small to successfully negotiate a settlement until after the debtor has made several months’ worth of payments.
2) Settlement damages credit
The debt settlement damages the scores in credit report temporarily but as debtors settle their accounts the score starts to go back up again. Some Debt Settlement companies offer Credit Repair in their programs in order to erase some of the negative remarks on credit reports. A credit report is used by creditors to judge past credit performance to see if the applicant meet their criteria for lending. Insurance companies uses a person’s credit report to determine premiums and prospective employers review the credit report to establish the character of a job candidate.
3) Tax consequences
Another common objection to debt settlement is that debtors whose debts are partially canceled outside the bankruptcy system will need to report the canceled portion of the debt as taxable income. (IRS Publication Form 982)
The IRS considers $600 or more of forgiven debt as taxable income.[citation needed] 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.”
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.
4)Criticism
In May 2009, the New York Attorney General issued subpoenas to fourteen “debt settlement” companies, looking for violations of New York law[8]. On May 19, 2009, the New York Attorney General filed suit against two “debt settlement” firms and their affiliates, alleging violations related to fraudulent business practices and false advertising.
A March 2010 CBS “Early Show” story on the debt settlement industry cast a harsh light on major debt settlement firm Credit Solutions of America’s business practices, and provided consumer advice for debt settlement counseling.
5) Trade associations
Due to the rise of debt settlement as a debt relief alternative to bankruptcy, groups working in the industry established trade associations to help secure industry standards that will protect consumers against unethical business practices.[citation needed] These trade associations were also established to lobby state governments because many state legislatures are passing laws that restrict out-of-state companies from providing debt negotiation services to in-state residents. The two major trade associations are the United States Organization for Bankruptcy Alternatives (USOBA) and The Association of Settlement Companies (TASC). Both of these organizations publish on their websites information about debt settlement and the debt settlement industry. Individual debt settlement consultants receive certification training (accreditation) from the International Association of Professional Debt Arbitrators (IAPDA).
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