Debt settlement
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[edit] Debt Settlement
A debt settlement is an agreement between a debtor and a creditor to fully satisfy a debt for a reduced payoff amount. A debt settlement is usually reached when a debtor is unable to fully meet his/her debt obligations due to financial hardships and attempts by the creditor to collect on the debt have failed. The creditor agrees to cancel part of the debt and accept the remaining sum as full repayment. Debt settlement is also called debt negotiation. Technically speaking, a debt settlement is the agreement while debt negotiation is the process through which both parties reach that agreement.
Consumers who use debt settlement are those who are experiencing legitimate financial hardships, cannot afford to repay their debts through debt management plans offered by consumer credit counseling agencies and who also want to avoid filing bankruptcy. For this reason, debt settlement falls between consumer credit counseling and bankruptcy.
Debt settlement programs are provided by third party debt resolution firms who set up payment plans, and then negotiate settlements on behalf of the consumer. Typically, debt settlement programs are able to lower monthly payment contributions to approximately half of the typical minimum monthly credit card payments, and get consumers debt free in a short period of time.
It is important to select a reputable provider, including a member of an industry association and a member of the Better Business Bureau (BBB).
[edit] Brief History of Debt Settlement
As a concept, lenders have been practicing debt settlement thousands of years ([1] Debt Forgiveness: Plainer Speaking, Please. by Stephen A. O’Connell). However, the business of debt settlement became prominent in America during the late 1980s and early 1990s when 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 [2]) increasing, banks established debt settlement departments staffed with personnel who were authorized to negotiate with defaulted cardholders to reduce the outstanding balances in hopes to recover funds that would otherwise be lost if the cardholder filed for Chapter 7 bankruptcy. The settlements ranged between 25% and 65% of the outstanding balance ([3] Sworn Testimony of Dr. Robert Manning, author of Credit Card Nation).
In the 1990s, entrepreneurs began establishing companies to negotiate debt settlements with creditors on the debtors’ behalf. Unlike the creditor supported consumer credit counseling industry, debt settlement companies are usually for-profit companies that charge fees for their debt settlement related services. Another stark difference is that debt settlement companies do not negotiate reduction in interest rates, distribute monthly payments to creditors or report enrollment to credit bureaus. Instead, debt settlement companies negotiate reduction of the outstanding balance of each debt in exchange for a lump-sum payoff or short-term installment payoff.
To support the debt settlement industry and develop standards and best practices, practitioners established the United States Organization for Bankruptcy Alternatives ([4] USOBA) in 2004. In 2005, industry leaders established The Association of Settlement Companies ([5] TASC) to fight “unfair and ambiguous debt management legislation” in Texas and broadened its focus to all fifty states after its successful Texas campaign.
[edit] The Debt Settlement Process
Whether a debtor enrolls in a professional debt settlement program or negotiates settlements directly with creditors, the process is the same. The debtor will save up and set aside money to build up a settlement fund. Once enough funds to make a reasonable settlement offer accrue, the debtor or his/her professional debt negotiator will negotiate with the creditor for a reduced payoff amount, typically between 25% and 50% of the outstanding balance.
Once the creditor agrees to a settlement amount, payment is arranged and the account is considered settled-in-full (as opposed to paid-in-full). The debtor continues saving up and setting aside funds into the settlement fund to accrue enough funds for negotiating a settlement for the next willing creditor. Essentially, the process is a cycle of saving up and setting aside money, negotiating a settlement and paying the settlement.
[edit] Debt Settlement Compared to Debt Management Plans through CCC
Debt settlement programs are often confused with debt management plans serviced by the consumer credit counseling industry. However, debt settlement programs are very different from debt management plans (DMP).
In a DMP, the credit counseling agencies works to lower the interest rate on the credit card account in hopes of lowering the monthly payment and causing more funds to go towards paying off the principal instead of the interest charges. The result of this is faster payoff of enrolled debts. The payments for different debt accounts are consolidated into one payment to the credit counseling agency who then distributes the payment to each creditor based on a scheduled repayment plan, usually lasting between five and seven years.
In a debt settlement program, the debt settlement company negotiates with the creditor to lower the outstanding balance of the debt. The debt settlement company does not negotiate lower interest rates and does not distribute monthly payments to creditors. The debt settlement company, usually through a third party payment processor, arranges for paying off debts once a reduced-balance settlement agreement is reached between the debtor and the creditor. The debt settlement client does make monthly deposits into their settlement fund, usually managed by an independent, third-party payment processor.
[edit] Types of Debts Eligible for Debt Settlement
Normally, only unsecured debts, like credit card and medical debts, can be negotiated for settlement. Secured debts, like home and car loans, cannot be negotiated because the creditor usually can repossess the item purchased with the credit issued to the borrower. If the debtor decides to enroll in a debt settlement program serviced by a professional debt settlement company, the amount of debt enrolled must usually total at least between $7,500 and $10,000, depending on the company. Some companies accept smaller debt loads.
[edit] Debtor’s Incentives
The debtor’s primary incentive for enrolling in a debt settlement program or engaging in direct debt negotiations with creditors is to payoff debts according to the debtor’s financial ability (which is likely strained due to financial hardships, such as unemployment, loss of income, medical expenses or other financial burdens). The other major incentive is to stay out of bankruptcy, which is reported on the debtor’s credit file and can remain on file for the next ten years.
[edit] Creditor’s Incentives
The creditor’s primary incentive is to recover funds that would otherwise be lost if the debtor filed for bankruptcy. 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 ([6] Direct Recovery Associates). 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 ([7] MSN Money: Zombie debt collectors dig up your old mistakes). Collection calls and lawsuits often push debtors into bankruptcy, in which case the creditor often recovers no funds.
[edit] Common Objections to Debt Settlement
There are four main objections to consumer debt settlement: damages credit, increased collection calls, possibility of lawsuits and tax consequences.
Damages Credit
The process of negotiating and reaching debt settlements with creditors requires the debtor to save up and set aside money into a settlement fund from which settlements are paid. However, due to the debtor’s financial hardship, the debtor is unable to make minimum payments towards credit card debts while saving up and setting aside money to payoff settlements. This inability to pay credit card bills while saving up money to payoff settlements results in the credit card company reported non-payment to credit bureaus (credit reporting agencies: Equifax, Experian and TransUnion).
Because payment history accounts for 35% of the FICO credit score calculation ([8] myFICO: What’s In Your Score), reports of non-payment to a debtor's credit file will lower the debtor’s credit score and reflect negatively on the debtor’s credit report.
The counter argument made by the debt settlement industry is that the good credit and the loose lending practices of the credit card industry enables consumers to accumulate an overwhelming amount of debt and all it takes is one financial hardship to interrupt the consumer’s ability to continue scheduled debt repayment. The other counter argument is that a consumer’s financial wellbeing is not always directly tied to their credit score and maintaining a credit score at the expense of basic needs is harmful to the consumer and the consumer’s family.
Increased Collection Calls
Another argument against debt settlement is that the failure to continue scheduled debt repayment results in increased debt collection activities that cause the debtor undue stress.
The counter argument made by the debt settlement industry is that many debtors are already being hounded by collection calls by the time they enroll in a debt settlement program. Many debt settlement companies offer assistance with alleviating collector calls and educate consumers about their rights as debtors as codified in the Fair Debt Collection Practices Act (FDCPA). Some companies actually change the phone number and address of their clients with the creditors to ensure that deal exclusively with the credit card companies.
While the FDCPA applied only to third-party debt collectors (not to creditors), some states passed legislation to supplement the FDCPA and to include creditors in their state consumer protection laws regarding debt collection.
Possibility of Lawsuits
The fear of lawsuits is often an objection to debt settlement.
The counter argument made by the debt settlement industry is that while creditors have the right to take legal action to collect on a delinquent debt and such lawsuits are filed against debtors, such lawsuits are not as common as the threats of lawsuits. Debt collection lawsuits rarely make business sense because the costs, time and other resources involved in legal action usually outweigh the return on these investments, even after receiving a judgment. Often, legal threats are made by collectors in an effort to make the debtor give that creditor account a higher pay-off priority.
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 Form 980)
The Internal Revenue Service 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.” ([9] IRS Publication 525)
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.
