How Debt Settlement Works
Essentially, the debt settlement company negotiates on the borrowers’ behalf with creditors to reduce the overall debts in exchange for an agreement upon regular payments to be made. Only credit card and unsecured debts can be handled, not student loans, auto financing or mortgages. For the debtor, this makes obvious sense — they avoid the stigma and intrusive court-mandated controls of bankruptcy while still lowering, sometimes by more than 50%, their debt balances. Whereas, for the creditor, they regain trust that the borrower intends to pay back what he can of the loans and not file bankruptcy (in which case, the creditor risks losing all monies owed).
There are obvious drawbacks — credit reports will show evidence of debt settlements and the associated FICO scores will be lowered as a result. There’s always the possibility of lawsuit whenever debts lay unpaid. Since few creditors wish to push borrowers toward bankruptcy — and the potential of governmental protection against all debts.
In addition, the specific debts of the borrowers themselves affect the success of negotiations. Tax liens or domestic judgments, for reasons that should be clear, remain unaffected by attempts at settlement. Student loans, even those not federally subsidized, have been granted special powers by recent legislation to attach bank accounts without possibility of Chapter 7 bankruptcy protection. Also, some individual creditors, including Discover Card, for example, tend to have an aggressive resistance against negotiations.
Debt Settlement Companies
In order to work with a debt settlement company, a consumer needs lump sum cash (best scenario), or build up enough funds over pre-determined period of time. Once enough funds are built up the negotiation process can begin with each creditor individually. Account can be held by credit card companies or may be sold to collections agency for average of $0.15 on the dollar. In which case debts can still be negotiated. The debt settlement company negotiates with the credit card companies for 35% - 50% of the existing balances. The debt settlement companies typically have built up a relationship during their normal business practices with the credit card companies and can come to a settlement agreement quickly. Once the consumer pays the agreed upon amount, the debt settlement companies take a percentage of the savings of the forgiven debt as the fee. With the current economic crisis, more and more credit card companies may be willing to settle existing credit card debts rather add to their already large written off bad debt.
Some companies work with consumers who have no cash to make settlement offers with the credit card companies. These companies set up "trust" for you — though they are not always a licensed bank entity under the Federal Reserve. They collect a monthly fee to maintain the account, with the idea being that you are saving enough money to settle the accounts at a future date. A portion of the monthly payment towards the "savings account", a part of the payment is taken as a fee for the debt settlement company.
Unlike consumer credit counseling services, they do not pay your creditors each month, they put money into your "trust". Your creditors are not told of your "arrangements" with the debt settlement company. A legitimate company will use an FDIC insured company for the trust account and give you access to it online 24 hours per day. They should also provide you with access to the negotiation correspondence with the credit companies.
The drop out rate of consumers from debt settlement companies is high. The debt settlement company may or may not handle calls from the credit card companies, or the collection agencies. Credit card accounts typically go into collection after they are charged off, typically 180 days after the last payment on the account. The length of the program is often 1-5 years, and many consumers cannot keep up the payments for this period of time. Often, consumers wind up being sued or even more deeply in debt with added interest and fees piling up. This can be avoided by using companies with good standings and practices that protect consumers from these procedures.
Creditor’s Incentives
The creditor’s primary incentive is to recover funds that would otherwise be lost if the debtor filed for bankruptcy. The other key incentive is that the creditor can often recover more funds than through other collection methods. Collection agencies and collection attorneys charge commissions as high as 40% on recovered funds. Bad debt purchasers buy portfolios of delinquent debts from creditors who give up on internal collection efforts and these bad debt purchasers pay between 1 and 12 cents on the dollar, depending on the age of the debt, with the oldest debts the cheapest. Collection calls and lawsuits often push debtors into bankruptcy, in which case the creditor often recovers no funds.
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