Negatives of Debt Settlement

For consumers who are drowning in credit card debt, a debt-settlement program can sound like the answer to their prayers. Debt-settlement companies claim to be able to negotiate with creditors and settle the debt for a one-time payment of 20 to 75 percent of what is owed, according to MSN Money.com. Unfortunately, it isn't quite that simple. In fact, there can be a variety of negative consequences from entering into a debt-settlement program.

Expense

Debt settlement companies charge a fee, which can be substantial, for their services. According to the National Consumer Law Center, fees of for-profit debt settlement companies can range from 15 to 18 percent of the total debt owed, 25 percent of the debt savings or a flat monthly fee for the duration of the program, depending on the company. Using the first method as an example, if you owed $30,000 in credit card debt, you could be charged up to $5,400 in fees. Some companies will even collect their fees up front before any money accrues in your settlement account.

Tax Implications

In addition to paying a fee, any amount of debt savings over $600 is considered taxable income by the IRS. If your settlement saves you $10,000 and you're in the 15 percent tax bracket, you'll owe an additional $1,500 in income taxes.

Not Always Available

According to Vera Gibbons, a financial contributor to "Early Show" on CBS, a growing number of credit card companies are refusing to work with debt-settlement firms, which you may not discover until after you've paid the fee and the debt-settlement company can't persuade your creditors to negotiate. Of those creditors who will work with a debt-settlement company, some won't do so until you are at least three to six months behind on your payments.

Misconduct

Debt-settlement companies don't have the best business reputations, as there have been widespread reports of possible fraudulent activities in the United States. The Federal Trade Commission reported that consumer complaints against debt-settlement companies quadrupled between 2006 and 2007. U.S. Attorney General Andrew Cuomo launched an investigation into the practices of 14 debt-settlement companies throughout the United States in 2009.

Damage to Your Credit

Although debt settlement could conceivably reduce you debt, it won't help your credit score. According to the National Foundation for Credit Counseling, a settlement company may tell you to stop paying on your credit cards and instead make payments to a third-party escrow account that the settlement company will use to negotiate the settlement. However, it could take six months or more to build up sufficient funds in the account. Interest charges and fees will continue to accrue during this period, which increases your debt and harms your credit.