The Dangers of Trusting a Debt Settlement Company

If you’re overwhelmed by bills and in need of debt relief, a debt settlement company promising to quickly wipe out your debt may sound ideal.

However, signing on with debt settlement companies comes with its own set of risks that could result in not only paying more in the long run, but doing more harm than good to your finances.

Here's a quick overview to help you learn more about how debt settlement companies work, as well as some trustworthy alternatives, so you can make an informed decision if you need help getting out of debt.

How does debt settlement work and why is it risky?

Although there’s no guarantee it will work, debt settlement companies attempt to negotiate with your creditors to accept a smaller amount of money than what you owe. This is what’s meant by “settling” the debt.

A debt settlement company is typically a for-profit company that will try to make arrangements to settle your debts with debt collectors and creditors for a fee. These companies will often try to convince you to stop paying creditors during the negotiation process¹ until an agreement is made, something that could make the situation – and your credit score – worse.²

The longer your debt goes unpaid, the more it can hurt your credit. Since the debt settlement process can take up to 36 months or longer,³ you could wind up with serious, and lasting, damage to your credit score.

And if any amount of the debt is finally settled, even if it’s only a portion of the full amount you owe, be aware that debt settlement companies can collect their entire fee – upwards of 15% to 25% – after just a single payment is made.³

How debt settlement companies can make your financial situation worse

On the surface, debt settlement may seem like the perfect solution. Unfortunately, it doesn’t always play out the way you hear it described in commercials. Here’s a summary of why using a debt settlement company is risky and likely to make your finances worse:

• You may sign away the ability to speak for yourself. A debt settlement company often directs the customer to sign a letter of authorization that directs a creditor to only communicate with the debt settlement company. In addition, all correspondence with the debtor (you!) is forwarded to the debt settlement company. That means zero direct communication between the lender and debtor can take place. Short story? You pay them to talk to your lender, waiving your ability to do so.

• Debt settlement companies can’t always settle 100% of your debt. Even if they only settle a portion of your debt, once an agreement is made, you’re required to pay them for their services (as well as your creditors).³

• It can hurt your credit score. This is because debt settlement companies usually tell customers to stop making payments on their debts.³ But just because negotiations are underway doesn’t mean those payments aren’t due. As we mention above, you can still be hit with late fees and penalties, and missed payments can still be reported to the credit bureaus and affect your credit score. Creditors can also get third-party debt collectors involved, something that may make your situation even worse.

• The money you saved could be considered taxable income. Debt settlement can involve a process called debt forgiveness. You won’t owe money to a creditor anymore, but you may be taxed by the IRS on debt that was forgiven.

• Finally, the biggest risk with seeking debt relief through a debt settlement company is that creditors are not required to negotiate with them in the first place. They can’t settle debt if creditors refuse to talk to them.

Alternatives to debt settlement companies

Working with a debt settlement company isn’t the only way out of debt. Here are some reputable options for debt relief:

1. Talk to your creditors. It sounds simple, but sometimes calling your creditors can be one of the best tactics to get out of debt. You may be surprised how willing lenders are to work with you. A single call may yield a lower interest rate or lower monthly payment.

2. Nonprofit consumer credit counseling services can help with household budgeting, bankruptcy counseling, first-time home ownership, student loan debt and more. They also offer debt management counseling. These organizations can help you develop a plan to get out of debt and take control of your finances. In some cases, these services are free of charge.

3. Debt consolidation. This is when you take out a new loan and use it to pay off a number of debts. A debt consolidation loan can be a sensible option to pay off things like medical bills, credit card debt and utility bills at one time. It can also streamline your finances by replacing multiple monthly payments with a single payment, and, if you qualify for a lower interest rate, may save you money over time. If you’re unfamiliar with debt consolidation, this primer on how debt consolidation works can help.

Do your research and be careful.

If you’re considering debt settlement, or any alternative option for debt relief, always carefully research each company and its services. Look for customer reviews, as well as information from organizations like the Federal Trade Commission, National Foundation for Credit Counseling, or the Consumer Financial Protection Bureau, which offer advice and answers to hundreds of different financial questions.

You don’t need to take our word for it. These trusted sources all agree that working with a debt settlement company can be dangerous:

• “That Offer to Make You Debt-Free? It Can Make You Worse Off,” The Wall Street Journal
• “There’s No Shortcut to Debt Relief,” The Washington Post
• “The Dangers of Debt Settlement,” The Balance
• “Debt Relief Services & The Telemarketing Sale Rule: A Guide for Business,” Federal Trade Commission

Remember, working with a debt settlement company is risky and can negatively impact your future. Your lender is eager and willing to talk to you about options, can provide free answers to questions and will help if you have concerns over loan payments. Whatever your financial situation, know that the free resources above are available to help you understand your options and choose a safe alternative.