What is Debt Settlement?

Debt settlement, also known as debt negotiation, debt arbitration or debt workout, is an aggressive approach to debt reduction in which the creditor agrees on a reduced amount, paid by debtor, 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, and creditors then become willing to settle for less than the balance owed.

Consumers can arrange their own settlements by using advice found on web sites, hiring lawyers to act for them, or using debt settlement companies. Some settlement companies may charge a large fee up front. Some 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 thousands of years. However, the business of debt settlement became prominent in America during the late 1980s and early 1990s. 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.  These departments were staffed by personnel who were authorized to negotiate with defaulted cardholders.  The purpose was to reduce the outstanding balances to recover funds that would otherwise be lost if the cardholder filed for Chapter 7 bankruptcy.

Typical settlements ranged between 25% and 65% of the outstanding balance.

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. They reduce the overall debts in exchange for an agreement for  regular payments to be made. Only 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. There’s always the possibility of lawsuit whenever debts lay unpaid.

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 or domestic judgments remain unaffected by attempts at settlement for reasons that should be clear.

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 to build up enough funds over a pre-determined period of time. Once enough funds are built up, the negotiation process can begin with each creditor individually. The account can be held by credit card companies or may be sold to a collection agency for an average of $0.034 on the dollar (2007), in which case debt can still be negotiated. The debt settlement company negotiates with the credit card companies for 35% – 50% 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 quickly. Once the consumer pays the agreed upon amount, the 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 add to their already large written-off bad debt.

Creditor’s incentives

The creditor’s primary incentive is to recover funds.  If the debtor files for bankruptcy, the creditor can potentially lose the entire amount. 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 only pay between 1 and 7 cents on the dollar. So the creditor typically recovers more in a debt settlement agreement than they would with attorneys or bad debt purchasers.

Common objections to settlement

There are five main objections to consumer debt settlement: damaged credit, increased collection calls, possibility of lawsuits, tax consequences and the need to settle with all creditors.

Settlement damages credit

The debt settlement damages the scores in credit report. A credit report is used by creditors to judge past credit performance to see if the applicant meet their criteria for lending. Insurance companies use a person’s credit report to determine premiums and prospective employers review the credit report to establish the character of a job candidate.

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.

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. 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.

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Jesse Niesen
DebtGOTOGuy.com
Debt Relief Guide Online
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