Debt settlement companies typically operate by offering consumers a promise to resolve their unsecured debt (like credit cards or medical bills) for less than the amount they originally owe. The fundamental mechanism involves instructing the client to stop making payments to their creditors immediately. Instead, the consumer deposits a negotiated monthly amount into a dedicated, third-party escrow or special savings account managed by the settlement company.
This period of non-payment is critical, as it allows interest, late fees, and penalties to accumulate on the consumer’s original accounts, signaling to the creditor that the consumer is in financial distress and making them more willing to negotiate a settlement before sending the debt to collections or suing. Many creditors will also sell the account to a junk debt buyer if it is not resolved within a time frame that the creditor requires. Junk debt buyers are typically very open to negotiating when there is an attorney, or at least the appearance of one, on the other side.
Once the consumer’s dedicated savings account holds a sufficient balance (which can several months if not years), the debt settlement company, begins reaching out to creditors or third-party debt collectors to negotiate a settlement that might be a lump-sum payment or one that involves payments over time. If a settlement is reached, the payment is made from the consumer’s savings account.
The settlement company then collects its fee—which can be quite large, even if the debt is not paid off yet, and sometimes before a payment to the creditor has even been made. Some will even take their fee before negotiating an agreement with a creditor, despite federal and state laws to the contrary.
Why is this bad?
However, the nature of the process carries significant risks that are often downplayed or ignored by the debt settlement company. Because the consumer ceases payments, their credit score suffers immediate, severe, and irreparable damage due to repeated late payments and subsequent charge-offs, which can take up to seven years to fall off a credit report. Furthermore, while saving up the settlement funds, the consumer is exposed to the substantial risk of being sued by creditors, who are under no legal obligation to negotiate.
Finally, any portion of the debt that is forgiven is generally considered taxable income by the IRS, meaning consumers can receive a 1099-C form and may face a hefty tax bill on the amount they thought was forgiven.
Many of these ‘savings’ accounts have monthly fees for keeping the money there. This is a great source of revenue for these companies that usually doesn’t comply with state laws, particularly if the debt settlement company is presenting themselves as a law firm.
Can it get worse?
Another pain point is when the creditor won’t negotiate with the debt settlement folks such that they can get the debt reduced to an amount that they agreed to. This will result in having to increase the monthly payment. Many times the total amount of the debt and the debt settlment fee exceed what the debt was before it was negotiated. The consumer pays for the privilege of having their credit destroyed.
As mentioned above, the creditor doesn’t have to negotiate with these companies. And, in fact, they can, and very often do, sue the consumer when they don’t get paid. This seems to happen when the debt settlement reps are waiting for the consumer’s account to have sufficient funds to pay their fees before they are willing to negotitate. Once the consumer is sued, the companies usually ghost their victim.
Sometimes they do promise a defense of the lawsuit, but this rarely occurs, and when they can’t get an attorney to handle it, then they ghost the consumer. The consumer is left with a default judgment and has their wages or bank accounts garnished. And, in many cases, the lawsuit could have been defeated by a half way competent attorney if they just showed up. But all too often they don’t.