The advertisements sound promising: “Pay only a portion of your balance!” “A legal way to reduce your debt load — fast!” Yet, are debt settlement companies as effective as they say they are? Will they be able to settle with your creditors so that you can pay “pennies on the dollar?”
Probably not.

Debt settlement is quicker than bankruptcy, but that does not mean that it will be successful. While debt settlement works for some consumers, many others end up more in debt than when they started. The debt settlement industry admits that debt settlement only works for one third of its clients. And their numbers are quite generous. According to the federal government, debt settlement is successful less than 10 percent of the time.

The Costs of Working With Debt Settlement Companies

Even when debt settlement is successful, it is costly — much more costly than other debt relief options, such as bankruptcy. Not only will debt settlement companies charge up-front fees for taking out loans before a settlement, but they will also usually ask for a hefty percentage of each forgiven debt. One Florida debt settlement company asks for an initial service fee that is nearly $7,000 as well as monthly “set-aside” fees that are in the hundreds of dollars. Another debt settlement company retains nearly $6,000 in fees even when they are unsuccessful in settling their client’s debt.
Furthermore, creditors may report the debt forgiveness to the IRS, who can tax you on the full amount of the debt reduction unless you are insolvent.

Finally, debt settlement can leave you in a worse position with creditors than you are in now. Debt settlement companies ask you to default on your debts because many creditors will not negotiate with consumers who are current on their bills. Unfortunately, defaulting can leave you with fines, higher interest rates, potential wage garnishment and even litigation. Once creditors know you are working with a debt settlement company, they are often more aggressive on their debt collection efforts.

Bankruptcy: A Better Option

So what do you do? It can be hard to accept that the “easy way out” — debt settlement — is through a locked door. Yet, there are other, more permanent options; options that can lead you to financial freedom. If you find yourself overwhelmed with debt, consider filing for Chapter 7 or Chapter 13 bankruptcy.
Chapter 7 bankruptcy allows debtors to discharge most of their debts while keeping their home and other exempt assets. Chapter 13 bankruptcy allows debtors to pay back some of their debts through a 3- to 5-year bankruptcy plan and discharge others.

Source: NACBA, “The Debt Settlement Trap: The #1 Threat Facing Deeply Indebted Americans”, Oct. 2012