When debt relief does more harm than good
In a crisis, long-term planning can lose out on quick and dirty solutions, whatever the consequences.
As the pandemic and its economic fallout continue, more cash-strapped consumers could fall into this trap if the Great Recession is any indicator.
A recent report from the Consumer Financial Protection Bureau found that from 2007 to 2010, debt settlements – which can be financially risky – increased. Meanwhile, credit counseling, a debt relief option that keeps consumers in good standing with their creditors, has declined.
Before moving to a crisis decision-making moment, understand how to think debt relief options.
Why isn’t debt settlement all it’s meant to be
You’ve probably heard the commercials on the radio or maybe received a robocall promising a solution to your debt that can reduce what you owe by 50% or more.
Debt settlement demands are as high as the industry’s marketing budget. But these programs aren’t all they’re meant to be – and the ads gloss over the downsides.
With debt settlement, you stop paying creditors and instead direct your money to the debt settlement company, which holds it in an escrow account. Then, usually after several months, the company contacts your creditors and negotiates to make a deal where the creditor accepts less than was originally owed. That waiting period between when you stop paying creditors and the debt settlement (which is unsecured) is when things can go wrong.
“There is no free lunch,” says Glenn Downing, a certified Miami financial planner. “There are really important trade-offs with debt settlement. I would try to make it a last resort.
The risks of debt settlement include:
- Exposure to lawsuits: When you stop paying your creditors and your debts go unpaid, you can be sued by the original creditor or by a debt collector who buys the debt. Until the debt is resolved, whether through full payment, settlement or bankruptcy, you run the risk of being sued.
- Tax Duty: The IRS considers any amount of debt settled as taxable income.
- Save less than advertised: Debt settlement companies often charge around 30% of your original debt balance. So even if you’ve paid 50 percent of what you originally owed, you won’t come out as far as you expected after paying the fees to the settlement company. In addition, your debt may continue to increase when you stop making payments, as late fees and interest are added to your balance.
- Credit-Related Damage: Missed payments and defaulting on your debts are among the worst things you can do to your credit. These marks stay on your credit reports for about seven years and will make you appear risky to future creditors, which can prevent you from getting credit or having to pay higher interest rates.
A better choice for long-term financial health
What if there was a way to consolidate multiple credit card payments into one, at a lower interest rate, while still maintaining your good reputation with your creditors?
This is what non-profit credit counseling offer agencies. These organizations have agreements with many credit card companies that offer a lower interest rate in exchange for regular monthly payments over three to five years to settle your debt.
But many consumers are unaware of these benefits, according to a 2018 Harris Poll commissioned by Money Management International, a nonprofit credit counseling agency. He found that 62 percent of 2,012 respondents were unaware that credit counselors can consolidate multiple credit card debts into one payment. And 73% didn’t realize that credit counselors offer lower interest rates on credit card debt.
There are certain disadvantages if you use the services of a credit counseling agency. debt management plan. You usually need a regular income to qualify, and if you miss a payment, the deal can be terminated, leaving you to fend for yourself.
But for the long-term health of your credit profile, credit counseling is clearly the winner. This debt relief tool generally keeps consumers in good standing with creditors as they meet their obligations. The only damage to their credit profile would come from the closure of credit accounts, which some agencies require.
Know when a third option might be best
Before choosing debt settlement or credit counseling, determine if:
- You are barely able to pay off your debts regularly.
- Your monthly debt repayments – excluding student loans and housing costs – exceed 40% of your take-home pay.
- Your debt interferes with your quality of life, for example by preventing you from sleeping at night.
If so, you might want to consider bankruptcy. Although it has been stigmatized, this debt relief tool can solve what you owe faster than credit counseling or debt settlement. Plus, credit scores can start to rebound quickly in the months after filing.
This article was written by NerdWallet and was originally published by The Associated Press. Sean Pyles is a debt writer at NerdWallet whose work has appeared in The New York Times, USA Today and elsewhere. Read more