Missed Payment Risks During Debt Settlement

Debt settlement can seem like an attractive option when you’re struggling with high credit card balances. The promise of settling your debts for a fraction of what you owe is certainly appealing. But before you sign up with a debt settlement company, it’s important to understand the potential risks, especially regarding missed payments during the program.

How Debt Settlement Works

With debt settlement, you stop making payments to your creditors and instead make monthly deposits into a dedicated account. The debt settlement company then negotiates with your creditors to try to get them to agree to settle your debts for less than the full amount owed. This can take many months to complete.

During this time, you are likely to miss payments and fall behind on your accounts. Debt settlement companies often advise – or even require – that you become delinquent before they will negotiate with your creditors. The idea is that creditors will be more willing to settle if they don’t think you can pay.

Risk 1: Damage to Your Credit Score

When you stop making payments on your credit cards and other debts, this will almost certainly hurt your credit score. Late payments, missed payments, and increased balances due to growing interest charges will drag down your credit.

For example, a FICO analysis found that someone with credit card debt between $5,000 – $10,000 could see their credit score drop by up to 100 points after just 3 months of missed payments. And the more severe the delinquency, the worse the damage.

Even after settlement, your credit report will likely show the account as “settled” rather than “paid in full.” Settled accounts are scored very negatively by credit scoring models.

Risk 2: Debt Settlement May Fail

There’s no guarantee that the debt settlement company will be successful in negotiating settlements, even if you go months without paying your creditors. It’s possible that creditors may refuse to settle your debts altogether.

If settlement attempts fail, you could end up worse off than when you started, with additional late fees and interest added to your balances. You may have to resume making payments, but now from an even deeper hole.

Risk 3: Tax Implications

If a creditor agrees to settle your debt for less than the full amount, the forgiven debt is generally considered taxable income by the IRS. So those $5,000 in credit card settlements could add $5,000 to your taxable income for the year.

Depending on your financial situation, you may or may not actually owe taxes on the forgiven debt. But it’s important to be aware of the potential tax consequences down the road.

Risk 4: Aggressive Collections

When you stop making payments, your creditors will likely turn up the heat on their collection efforts. You can expect frequent calls from collectors requesting payment. Creditors may even file lawsuits or pursue wage garnishment if allowed by state law.

The Fair Debt Collection Practices Act provides some protections against harassment by collectors. But the collections process can still be stressful and disruptive to your daily life.

Risk 5: Settlement Fees

Debt settlement companies typically charge fees based on a percentage of your enrolled debt. Fees often range from 15% to 25% of your total debt amount. So for example, settling $20,000 in credit card debt could cost you $3,000 to $5,000 in fees.

These fees are deducted from your dedicated account used to fund the settlements. If few or none of your debts are settled, you may get little in return for paying thousands in fees.

Risk 6: Scams

The debt settlement industry has long been plagued by scam artists looking to take advantage of financially vulnerable consumers. Some signs of a debt settlement scam include:

• Charging large upfront fees before providing any services
• Advising you to stop paying creditors immediately
• Making unrealistic claims about how much debt can be settled
• Telling you to stop communicating with creditors
• Not providing a contract detailing services, fees, and policies

Reputable debt settlement companies will be upfront about risks and fees. Be very cautious about any company that pressures you to sign up right away or avoid reviewing the contract.

Alternatives to Debt Settlement

Given the risks involved, it’s wise to consider alternatives before committing to a debt settlement program:

• Credit counseling – Nonprofit credit counseling agencies can help you set up a debt management plan (DMP) to repay debt through consolidated monthly payments. This won’t reduce principal but can help you get current and avoid late fees.
• DIY settlements – You may be able to negotiate settlements directly with your creditors without paying settlement fees. But this requires patience and good negotiating skills.
• Bankruptcy – While a last resort, bankruptcy may allow you to discharge credit card and other unsecured debt entirely through liquidation (Chapter 7) or a 5-year repayment plan (Chapter 13).

The right option depends on your specific financial situation. Speaking with a nonprofit credit counseling agency can help you understand all your alternatives.

Weighing the Pros and Cons

Debt settlement can be a reasonable option for some consumers – such as those with little income, no assets, and few options aside from bankruptcy. It may provide the fresh start they desperately need.

But it’s not a quick fix or an easy way out. The credit damage and other risks are very real. Success is not guaranteed. And the process requires discipline to save up enough to fund settlements.

Carefully consider both the potential pros and cons before deciding if debt settlement is your best course of action. Don’t let a debt settlement company pressure you into making a hasty decision. Speaking with a credit counselor and attorney can provide guidance tailored to your unique situation.

With some smart planning and diligent follow-through, debt settlement may help you resolve unaffordable credit card balances. But missed payments along the way can worsen your financial situation if you’re not prepared for the risks.

References

[1] https://www.experian.com/blogs/ask-experian/debt-settlement-risks/
[2] https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-relief-program-and-how-do-i-know-if-i-should-use-one-en-1457/
[3] https://www.nerdwallet.com/article/finance/how-does-debt-settlement-work
[4] https://www.consolidatedcredit.org/debt-solutions/debt-settlement/8-facts-about-debt-settlement-know-the-risks/
[5] https://www.experian.com/blogs/ask-experian/late-payment-debt-settlement-hurts-credit-scores/
[6] https://consumer.ftc.gov/articles/how-get-out-debt