Debt settlement is an interesting world with potential, and pitfalls. As a bankruptcy lawyer in Colorado, I advise clients of seven rules which can help you get the most out of debt settlement. However, I also add a Golden Rule to list – understand your options when attempting to settle debt. This includes understanding bankruptcy. Knowing the rules and your options will help you get the most out of your efforts to improve your financial situation.
The seven basic rules of debt settlement which I advise clients are as follows.
1. You must financial hardship in order to qualify. Financial hardship such as job loss is required because your creditors are not going to give you a break unless they fear you cannot pay them back.
2. You actually need to miss some payments. I know this sounds strange. How could your good faith efforts to make payments work against you? Well, your creditors have no reason to offer you a break on the debt you owe them as long as you continue to make payments. Sure, they may give you a lower interest rate if you give them a hard luck story, but you will not get significant reduction of principal balance on your debt until you miss some payments. Once you start to miss payments, you represent a greater risk to them and then you have negotiating leverage.
3. You need to offer a lump sum of cash. This is required because a lump sum removes their risk. In general, they are not going to reduce your balance if they continue to have risk. Without a lump sum, they are better off keeping the full amount of the debt on their books and pursuing judgment against you or selling the debt to a collection company, who will pay a lump sum (cents on the dollar) for that debt.
4. Most debt settles for 40% to 80% of what you owe. This means your lump sum will likely have to be this big. Of course, I suggest you start by offering 10% or 20%, but you may not get a deal done until you have 40% or more of what you owe in a lump sum.
5. You can settle debts yourself. There are companies which specialize in this, but settling debt is no magic trick. One of the primary functions these companies perform is advise you to stop paying your credit card bills and pay them some monthly amount instead. This has the effect of worrying your creditors (#2 above) while building a lump sum to offer them (#3). You can do this yourself. If you can save a lump sum by not making monthly payments to your creditors or you already have a lump sum, all you have to do is start missing payments. At that point, your creditors will contact you. Now you can begin the negotiations!
6. If you want to go with a debt settlement company, DO YOUR HOMEWORK. These companies often take your money to help you build up a lump sum. They are not a bank and this money is not FDIC insured. This is a recipe for you getting robbed. To avoid this, I suggest you choose a company from The Association of Settlement Companies (TASC). You may also want to choose a company with Better Business Bureau accreditation.
7. Be aware of the costs of debt settlement. The costs of debt settlement are generally threefold. First, debt settlement hurts your credit score. The effect is not as much as bankruptcy, but is nonetheless significant. Second, if you use a debt settlement company, they will generally charge some percentage of what they settle. This is generally more expensive than a bankruptcy attorney. Finally, the amount of debt forgiven is reported to the IRS as taxable income!! Depending on your tax bracket, this means you will pay 35% or more of the amount forgiven by your creditor to the IRS. I know – this makes the savings of settlement a lot less exciting.
Now that you know the seven basic rules of debt settlement, you’re ready for the golden rule of debt settlement. Drum roll please…………………………
GOLDEN RULE: Understand bankruptcy as an alternative to debt settlement. Depending on your income and assets, you could do much, much better in bankruptcy than debt settlement. This is primarily because many debtors can wipe out debt in bankruptcy without paying their creditors anything and without losing any property. This is also because the attorney’s fees and court fees for bankruptcy are generally much less than what a debt settlement company would charge. And the removal of debt in bankruptcy is NOT taxable. Many debtors wipe out tens or even hundreds of thousands of debt in bankruptcy for less than less than $5,000 (in many cases, for less than $2,000). Debt settlement can’t touch this kind of result.
If you have more debt than you can pay and are considering debt settlement, you should know the seven rules of debt settlement. However, before you go down that path, you should know your rights in bankruptcy. Many attorneys, such as myself, will give you a free consultation. Your creditors know their alternatives (pursuing judgment or selling your debt to a third party collection company). You should know yours. This will help you know how much you should pay to settle your debt, and it may keep you from trying to settle at all.