Debt settlement a bad alternative to bankruptcy

Debt settlement isn’t the Wild West industry it was a decade ago, when people routinely paid hefty upfront fees to companies that failed to deliver any relief.

Thanks to increased regulation and enforcement, the much smaller number of settlement companies that remain often do what they promise: persuade at least some of a borrower’s creditors to forgive part of the debt, typically in exchange for a lump sum payment.

Several people I’ve interviewed lately reported positive experiences with debt settlement, so I decided to take another look at the industry. It turns out that hiring a negotiator could be a reasonable alternative to bankruptcy for some. But debt settlement is not as consumer-friendly as the industry presents it, and some of the people who praised the companies didn’t fully understand their alternatives or the longer-term consequences of settling debt.

In my latest for the Associated Press, a look at the biggest problems with debt settlement.

Q&A: The hazards of debt settlement

Dear Liz: My wife and I owe about $46,000 in credit card debt. We are considering a debt consolidation plan in which our debt would be reduced to about $27,000. According to what I’ve read and what’s included in the paperwork, any reduction in our debt may be reported to the IRS as income. I’m assuming this would not only increase our tax burden but could result in the forfeiture of some of my Social Security benefits. Am I correct in these assumptions?

Answer: What you’re considering is debt settlement, not debt consolidation.

With debt consolidation, you get one loan to pay off other, smaller debts in full. The right debt consolidation loan would offer a fixed interest rate and would allow you to pay off what you owe within three to five years.

Debt settlement, on the other hand, means you’re trying to get your creditors to accept less than what you owe. Debt settlement typically requires that you stop making payments to your creditors, which will trash your credit scores and could lead to lawsuits. You typically accrue interest, late fees and penalties that could offset or even wipe out any savings the debt-settlement company is promising you.

And the fact that the company seems to be promising you specific results, such as a $19,000 reduction in your debt, is a red flag all on its own. Your creditors don’t have any obligation to settle with you, and a debt settlement company shouldn’t promise that it can make the debt disappear.

To answer your specific questions: Yes, any debt that is “forgiven” in a settlement is considered income that can be taxed. It isn’t considered earned income, however, and so doesn’t trigger the Social Security earnings test that can reduce your benefits.

You’d be wise to read what the Federal Trade Commission and the Consumer Financial Protection Bureau have to say about debt settlement on their sites. In the vast majority of cases, you’re better off avoiding this option. Pay off what you owe if you can. If you can’t, explore a debt management plan offered by a nonprofit credit counselor and also make an appointment with a bankruptcy attorney so you understand all your options.

Beware debt reduction offers

Dear Liz: What is your opinion of debt reduction programs? I am constantly receiving mail from various companies, and I was wondering if they are legit. They claim they can reduce my debt, which sounds promising, but I am hesitant to get involved with them.

Answer: You’ve got good instincts.

Many of the companies sending out these solicitations say they can settle your debt for pennies on the dollar. What they often fail to mention is that the debt settlement process can result in your being sued by your creditors and having your credit trashed. That’s assuming they try to settle your debt at all, rather than just disappearing with any money you pay them in advance.

If you’re struggling with too much debt, you should make two appointments: one with a legitimate credit counselor (visit the National Foundation for Credit Counseling at http://www.nfcc.org for referrals) to see whether you qualify for a debt management program to repay your credit card debt, and another with a bankruptcy attorney (check the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org for referrals) to see whether a bankruptcy filing might be appropriate for your situation.

Co-signing card leads to collectors’ calls

Dear Liz: I co-signed a credit card for someone and the person defaulted on payment. I started making payments but could not continue because I became unemployed. The debt started at $15,631.23 but has gone up to $17,088.08 because of interest and fees. I previously had to go to court because my bank account was frozen. I recently got a notice about this again. Should I file for bankruptcy or try contacting the attorneys who are seeking payment? I am working part-time and have a tight budget. I don’t have anything saved and am living from paycheck to paycheck.

Answer: You should have gone to a bankruptcy attorney the first time you got sued.

Many people try to ignore their debts or hope that collection agencies will be lenient. That’s not a good strategy at a time when collectors are increasingly willing to file lawsuits to get paid, said Gerri Detweiler, director of consumer education for Credit.com. Once collectors have a judgment against you, they can freeze your bank accounts or garnishee your paycheck.

If you don’t have anything saved and can’t come up with any money for payments, you have little leverage in dealing with a collection agency. Bankruptcy may be your only recourse to get these collection efforts to stop.

A bankruptcy attorney can let you know whether you are “judgment proof,” which basically means that you have and make too little for a creditor to collect on any judgments. If you are judgment proof, you may not need to file for bankruptcy, but you may have to deal with frozen accounts and regular trips to court when a collector oversteps.

You can get a referral from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org.

The only silver lining of this situation is that you’ve provided other people with a clear lesson in why they shouldn’t co-sign a credit card or any other loan for someone else.

Our #CreditChat is about to begin!

liz-westonIn a few minutes I’ll be answering your questions about how to deal with your debt on Experian’s #CreditChat, which starts at 3 p.m. Eastern/noon Pacific today. Topics include how to balance savings and paying off debt, which debts to tackle first, how to handle student loans and what to do if you’re drowning in debt. Easy ways to follow the conversation include Twubs or tchat.

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Be careful when settling old debts

Dear Liz: I paid all of my old collection accounts except for two, which now are beyond the statute of limitations. I would like to find the best way to negotiate with the collection agencies without getting sued. Even though the original delinquency was over four years ago, the agencies are reporting these every month as current debt, which is really hurting my credit score. My intent is to offer a lump-sum settlement amount if they will remove the report from my credit file with the bureaus, or alternately in return for a “paid” notation on my report file. However, I cannot afford to pay the amount they say I owe.

Answer: If the collection agencies are simply reporting your debts each month with a correct “date of last activity” — usually the date you stopped paying the original creditor — your credit scores aren’t being hurt anew each month. If the agencies are reporting a new date of last activity each month, however, they are illegally re-aging your debts. You can dispute this illegal reporting with the credit bureaus and directly with the collection agencies. If the errors aren’t corrected, you can file a complaint with the Consumer Financial Protection Bureau, which took over regulation of the major credit bureaus last year.

Filing disputes is not something you’d want to do if the debts are still within the statute of limitations, said Michael Bovee, president of Consumers Recovery Network, which specializes in debt settlement. You wouldn’t want to draw attention to yourself or your debts. But you run little risk in filing a dispute now since the debts are too old for the collectors to file a legitimate lawsuit.

Bovee said that simply contacting the agencies about the debts shouldn’t restart the statute of limitations, but debt expert Gerri Detweiler of Credit.com advised caution.

“It may be well worth it to consult a consumer law attorney,” Detweiler said. “Otherwise [you] may reset the clock on these debts and owe the entire amount plus interest.”

You can get referrals to consumer law attorneys at the National Assn. of Consumer Advocates, http://www.naca.net.

You don’t have to pay the reported debts in full to reach a settlement, Bovee and Detweiler agreed. Often the totals reported are inflated by interest and fees, and the collection agencies probably paid only pennies on the dollar to buy this debt.

Start by saying you have only so much money to work with and offer 20% to 30% of what the agency says you owe.

“A realistic expectation for negotiating a debt this old would be to settle the account for 50% or less than the current balance owed,” Bovee said. “If they raise objections, there is no problem in mentioning that you are aware that the debt is past the statute of limitations for you to be sued, but that you are just trying to do the right thing.”

Don’t say you’re trying to improve your credit, since that gives the collector leverage over you, Bovee said.

You can negotiate to have the collections deleted from your credit reports, but the original delinquencies and charge-offs will remain and will continue to affect your credit scores until they pass the seven-year mark.

Settling co-signed student loan debt

Dear Liz: My daughter co-signed a student loan for a friend who failed to pay the debt. Now my daughter cannot refinance her home because this loan appears on her otherwise very good credit reports. She has been getting calls from a collection agency.

I called the agency to discuss what it would cost to get her released from all liability regarding this loan, and they gave me an offer of $13,000 to satisfy the debt, which is now $35,000. I countered with $9,000, since the original loan was just $15,000, but they refused. My daughter is unhappy about paying anything, since her ex-friend is a gainfully employed attorney. Is it good business to pay what the collection agency is asking, or should I continue to negotiate?

Answer: That sounds like a pretty good offer, said financial aid expert Mark Kantrowitz, publisher of the FinAid and Fastweb websites.

“Lenders almost never settle for less than the outstanding principal balance of a defaulted student loan, so that may be the best she can get,” Kantrowitz said. “It may be the case that they are offering her a low settlement amount to release her from her obligation and then will go after her former friend for the remaining debt. When there are two borrowers on the hook, one borrower reaching a settlement does not cancel the debt. It merely releases that borrower from her obligation.”

Your daughter should have the settlement offer reviewed by an attorney, Kantrowitz said. The attorney should verify that the collection agency has the authority to settle the debt, and any agreement should list all of the loans involved.

“I’ve seen cases where a borrower thought she was getting a settlement of all the loans,” Kantrowitz said, “but the settlement was just for some of the loans.”

Ideally, the settlement agreement would require the lender to stop reporting the default and delinquencies to the credit bureaus, which would remove the stain from her credit reports. Not all lenders will agree to such a condition, Kantrowitz said, but removal would be better for her credit than simply having the debt reported as “satisfied.”

Also, the agreement should require that the lender provide a “paid in full” statement to your daughter as proof her debt has been settled, Kantrowitz said.

“She should keep this statement forever,” Kantrowitz said, “as defaulted loans have a tendency to resurrect themselves from time to time, [such as when] a bank reloads their database from old backup tapes [or] someone reviewing old records discovers the original promissory note.”

An attorney also could advise your daughter about taking further steps, such as suing the former friend for repayment or reporting the issue to the state bar, which has standards of professional conduct that may be violated by an unpaid debt.

Huge debts? Where to find help

Dear Liz: My husband and I are in a huge amount of debt. I understand that there are nonprofit agencies that can sit down with us and help us develop repayment plans and strategies. How do I find a reputable one?

Answer: Contact the National Foundation for Credit Counseling at (800) 388-2227 for a referral to a legitimate, accredited, nonprofit credit counseling agency in your area. A counselor can review your financial situation, help you with budgeting and see whether you’re a candidate for a debt management plan, which would allow you to pay off your credit card debt over time, perhaps at a lower interest rate.

You also should consider making an appointment with an experienced bankruptcy attorney. You can get referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org. A credit counselor may try to steer you away from bankruptcy, whereas an attorney can let you know if it might be a better option.

Unfortunately, many people wait too long before they contact a credit counselor. They may be approved for a debt management plan but find themselves unable to stick with the plan long enough to pay off their debt. In other words, they continue to struggle with debt that they ultimately can’t pay. Understanding all your options, including bankruptcy, can help you make a better choice about what to do next.

Old debts don’t disappear

Dear Liz: I am astonished you would counsel someone to try to negotiate a settlement of credit card debts from 2003 that were written off in 2007. Why? The statute of limitations is no more than six years in California and can be much shorter in many other states. If a reader of your column begins to negotiate over debts that are that old, they risk creating a new debt or resurrecting the old one, thereby becoming liable for repayment of a debt that is not collectible. When there is a stale claim, the response to the collection agency needs to be: “This is a stale claim, the statute of limitations has expired. I do not owe this debt to you or to my original creditor. Please stop contacting me.”

Answer: Statutes of limitations limit how long a creditor is supposed to be able to sue a borrower in court. The statutes vary by state and the type of debt, but range from three to 15 years. The expiration of that limit doesn’t make the debt somehow disappear or prohibit a creditor from continuing collection efforts.

Many people feel a moral obligation to pay their debts when they can. Others want to negotiate to remove collections from their credit reports in return for payment. (Time limits for reporting negative items on credit reports are different from state statutes of limitations; in most cases, the limit is seven years and 180 days from the time the account first went delinquent.) If someone wants to get a mortgage, for example, a lender may require payment of an open collections account regardless of the state statute of limitations.

You’re correct that anyone who wants to negotiate a settlement of an old debt should be aware of the statute of limitations affecting that debt. If the limitation hasn’t passed, the borrower needs to be aware of the danger of getting sued. If the limitation has passed, the borrower needs to avoid restarting it by making a small payment. Instead, the best approach is to settle for a lump sum and to get the collector’s assurance, in advance and in writing, that the remaining debt will be forgiven rather than resold.