Middletown New York Bankruptcy Lawyer Discusses Debt Settlement Companies and Their Flawed Business Model

The Lament of Debt Settlement Customers

Many bankruptcy clients report nightmarish prior experiences dealing with a Debt Settlement Company, complaining that “everyone ended up suing me” and “none of my creditors got paid”, etc.  Dissatisfied Debt Settlement customers provide a steady stream of new clients for bankruptcy lawyers. These unhappy customers report being directed by the Debt Settlement Company to: not pay any attention to their creditors; refer any creditor calls or collection letters to the Company; don’t make any more payments to their creditors; if served with lawsuit papers just bring them to the Company for handling; each month deposit a chunk of money into a dedicated account established for debt settlement purposes; when the dedicated account contains a sufficient sum of money the Company will try to settle out with Creditor #1 (and collect their fee for such settlement); continue to deposit a chunk of money into the dedicated account each month, and when said account is sufficiently replenished the Company will try to settle out with Creditor #2, etc.

The Debt Settlement Business Model is Fundamentally Flawed

These nightmarish experiences are almost inevitable due to the Debt Settlement business model being fundamentally flawed.  While Creditors #1 (and possibly #2) are being attended to by the Company, Creditors #3, #4 and #5, etc. are being ignored and receiving no payments from either the Company or the customer.  These creditors do not sit back idly.  Rather they commence collection lawsuits against the customer that the Company generally cannot effectively deal with, as many of these Companies are not New York-based and have no local counsel to appear and defend collection lawsuits in New York courts.  In theory Debt Settlement can work if you have only one creditor, but that is not the typical profile of those soliciting debt relief services.

The Debt Settlement Process, in a Nutshell

A Debt Settlement Program involves a Debt Settlement Company (there are many, some more reputable than others), hired by the customer, negotiating with your creditors to try to settle your debts for a reduced amount.  The customer is generally required to establish a dedicated bank account and deposit a monthly amount determined by the Company into said account, with the goal being to create a pool of funds sufficient to finance future settlements reached with creditors.

The Many Shortcomings of the Debt Settlement Process 

• Creditors Have No Obligation to Negotiate with Debt Settlement Companies

The Company may be able to settle one or two of your debts, or possibly none at all.  Some creditors refuse to participate in Debt Settlement Programs, while others may participate but choose not to agree upon a settlement amount.  These unsatisfied creditors can and do choose instead to take you to court, which will add to your financial woes. You can end up settling a few debts and still have to file bankruptcy—the worst possible scenario, as the hard-earned monies you paid to settle the few debts are basically just thrown away.

• Debt Settlement Companies Only Address Unsecured Debts Like Credit Cards

To cite a few (of many) examples for illustrative purposes, mortgages and car loans that are not affordable cannot be addressed.

• The Debt Settlement Process Does Not Stop all Debt Collection Efforts and Does Not Prevent Creditors from Commencing Collection Lawsuits Against You

Creditors who obtain judgments are free to garnish your wages while you are participating in a Debt Settlement program, creating the challenging scenario of paying a monthly sum to the Company while at the same time having a judgment creditor garnish 10% of your salary.

• Forgiven Debt is Considered Taxable Income

If a creditor settles for less than the full amount owed, both you and the IRS will be sent a Form 1099-C for the amount that you were not required to pay.  The IRS views forgiven debt as income that you have to declare on your next year’s tax return and pay income tax on.

To illustrate, assume your Company settled a $10,00 debt for $5,000, and you are in the 20% income tax bracket.   While these matters should be discussed with your accountant, in most instances when you next file your tax returns an additional $1,000 will be due to the taxing authorities (20% of the $5,000 in forgiven debt).

• Debt Settlement Negatively Impacts Your Credit Rating More Than Bankruptcy

Late fees, interest and penalties continue to be assessed by creditors while the Company is attempting to settle your defaulted accounts, a process that can take up to four years.  In addition, any settled debt is generally reported to the credit bureaus as a “partial payment”, which will stay on your credit report for seven years.  Upon conclusion of a Debt Settlement Program it is not unusual for the customer’s FICO score to drop to the mid-500’s, which is about where it would be after a bankruptcy filing. In addition, your credit score will typically recover more quickly after bankruptcy than after a Debt Settlement Program. After a bankruptcy filing your credit score starts to improve surprisingly quickly, largely because your creditors are not permitted to report your credit history to the Credit Reporting Agencies after your case is filed. However, creditors in a Debt Settlement Program will continue reporting your derogatory credit history to the Credit Reporting Agencies until the last payment is made to the particular reporting creditor, which is often up to 4 years after the commencement of the Debt Settlement Program, and that negative reporting will remain on your credit report for seven years.

• Debt Settlement is Costly and Provides Minimal Benefit to the Customer

Debt Settlement Companies are for-profit businesses who, not surprisingly, collect substantial fees from their customers, although they can no longer (thankfully) charge upfront fees.  Most charge a percentage of each debt settled, usually 15%-25%, based upon (1) most frequently–the balance owed on the debt when you enroll in the program, or (2) occasionally–the amount of debt forgiven by the settlement.  To illustrate, assume the company settles an $11,000 debt for $6,000 and charges a 25% fee, with the customer being in the 20% income tax bracket—

• If the fee is based upon a percentage of the debt settled, the creditor gets paid $6,000, the company receives $2,750 (25% of $11,000 debt owed upon enrollment) and the income tax authorities receive $1,000 (20% of the $5,000 forgiven debt) to cover the increased income tax obligation. Total settlement cost:  $9,750.  Note:  this is 88.6% of the debt owed!
• If the fee is based upon a percentage of debt forgiven, the creditor gets paid $6,000, the company receives $1,250 (25% of $5,000 debt that is forgiven) and the income tax authorities receive $1,000 (20% of the $5,000 forgiven debt) to cover the increased income tax obligation. Total settlement cost: $8,250.  Note:  this is 75% of the debt owed!

In addition to the above fees and costs, the customer frequently incurs a set-up fee upon enrolling in the debt settlement program AND a monthly fee to maintain the dedicated bank account required to be set up under the program.  In short, THE MATH DOES NOT PROVIDE ANY SIGNIFICANT BENEFIT TO THE CUSTOMER.

Bankruptcy Compared to Debt Settlement

Debt Settlement Companies seem to constantly try to demonize bankruptcy, particularly in their late-night television advertisements.  However, an analysis of the two processes reveals a very different story.  Please consider the following:

• Impact on Credit Rating:

The assertion that bankruptcy is harder on one’s credit score than Debt Settlement does not withstand scrutiny.  Both processes tend to drop credit scores into the mid-500 range, and credit scores do begin to recover upon completion of either process.  However, the difference is that a Chapter 7 bankruptcy generally takes three months, whereas a Debt Settlement Program is usually up to four years long.  Credit repair begins much more quickly after bankruptcy.

• Bankruptcy Immediately Halts Debt Collection Activities, Including Lawsuits, and Ends Wage Garnishments:

Debt Settlement immediately halts nothing.  If creditors do not want to participate, they do not have to.

• Bankruptcy is Not a Business Negotiation Where Creditors Hold all of the Leverage:

In Debt Settlement the Creditors run the show and have the final say when it comes to making settlement offers.   Bankruptcy, on the other hand, is a legal process governed by federal law that all parties, including the creditors, must follow to the letter.

• No Federal or State Income Taxes are Owed on Debts Discharged in Bankruptcy:

The amount of debt forgiven in Debt Settlement is subject to both federal and state taxation.

• Bankruptcy is Much Less Expensive than Debt Settlement:

While there are legal and filing fees associated with preparing and filing a bankruptcy petition and making required Court appearances (usually one in a Chapter 7 case), the fees collected by the Debt Settlement Company tend to dwarf the fees paid out for a bankruptcy, and this does not even take into account the settlement sums paid to creditors and the income tax obligations that must be paid for any debt that is forgiven.

• Interest, Penalties and Late Charges End When a Bankruptcy is Filed:

 Debts discharged in bankruptcy are simply wiped out—end of story.  In Debt Settlement the interest, penalties and late charges continue to accrue throughout the process.

• Bankruptcy Can Discharge Many Types of Debts, Including Older Income Tax Debts and Some Secured Debts:

Debt Settlement Companies only deal with unsecured debts, like credit cards.  Bankruptcy offers a much broader spectrum of debt relief.

• The Debt Settlement Process Can Drag on for up to Four Years—a Chapter 7 Bankruptcy is About 90 Days from Date of Filing to Date of Discharge

Your debt is gone, and you get on with your life, much sooner after filing for bankruptcy than you do enrolling in a Debt Settlement program.

Governmental Warnings About Debt Settlement Practices  

Both the Consumer Financial Protection Bureau and the Federal Trade Commission have specific warnings on their websites to “Avoid Doing business with any company that promises to settle your debt if the company:

• Charges any fees before it settles your debts
• Represents that it can settle all of your debt for a promised percentage reduction
• Touts a “new government program” to bail out personal credit card debt
• Guarantees it can make your debt go away
• Tells you to stop communicating with your creditors, but doesn’t explain the serious consequences
• Tells you it can stop all debt collection calls and lawsuit
• Guarantees that your unsecured debts can be paid off for “pennies on the dollar”

To get complete, timely and affordable debt relief you should consider calling Michael O’Leary at Hayward, Parker & O’Leary (845-343-6227) to discuss using bankruptcy as your debt relief option.