Debt Settlement Dangers

Debt settlement companies are different than credit counselors. Debt settlement companies negotiate directly with your creditors for a lump sum payoff, not just for reduced interest rates or affordable payment plans. Debt settlement programs can have significant risk, so approach them with caution.

Fraud

Fraud is a concern when using debt settlement companies. Some firms might not have your best interests at heart. Sometimes, you pay high fees before the company negotiates the first settlement with your creditors. Some servicers present themselves as experts and well qualified, but in reality, aren't experienced or capable enough to confront creditors and work settlements. Some services are scams, just take their fees, and disappear.

Lawsuits

There is no guarantee that your creditors will work with a debt settlement company and accept a lower amount for a payoff. Most debt settlement companies work by having you make payments to them, and they hold the money until they have accumulated enough for a settlement with a creditor. Then, they call that creditor and begin to negotiate. In the meantime, the creditor could file a lawsuit against you. Some creditors do this even more quickly when they find out that you are working with a debt settlement company. The creditor could proceed to a judgment and a wage garnishment, leaving you even shorter on cash.

No Regulation

As of 2011, the federal government does not regulate debt settlement companies, although that could change. Some states provide oversight, but in states with oversight, debt settlement companies are less likely to offer their services. If you use a debt settlement company, it is completely at your own risk.

Taxes

The IRS considers debt settlement to be debt forgiveness. The creditors you settle with will send you Form 1099-C, stating that the forgiven amounts are taxable income. For example, if a creditor forgives $10,000 in debt, that $10,000 would be added to your taxable income for the year. If you are in the 25 percent federal tax bracket, you would owe $2,500 in additional federal income taxes on that $10,000 in forgiven debt above and beyond your normal tax bill. While you would still be saving money over paying the original debt, you need to be prepared to pay the taxes, or you could owe the IRS instead of the creditor.

Other Dangers and Concerns

You take a significant hit to your credit when settling debt, although most of the damage may have been with seriously late payments. Debt settlement often takes two years to three years, whereas a Chapter 7 bankruptcy takes about four months if you qualify. Debt settlement firms frequently charge from 14 percent to 18 percent of your total debt amount for services that you may be able to do yourself.