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Debt Settlement
Also known as Debt Arbitration or Debt Negotiation, is an aggressive approach to debt reduction. |
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Brief history of debt settlement |
As a concept, lenders have been practicing debt settlement thousands of years However, the business of debt settlement became prominent in America during the late 1980s and early 1990s when bank deregulation, which loosened consumer lending practices, followed by an economic recession placed consumers in financial hardships.
With charge-offs (debts written-off] by banks) increasing, banks established debt settlement departments staffed with personnel who were authorized to negotiate with defaulted cardholders to reduce the outstanding balances in hopes to recover funds that would otherwise be lost if the cardholder filed for Chapter 7 bankruptcy. The settlements ranged between 25% and 65% of the outstanding balance. |
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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 only pay between 1 and 7 cents on the dollar. Collection calls and lawsuits often push debtors into bankruptcy, in which case the creditor often recovers no funds. |
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Common objections to debt settlement |
There are five main objections to consumer debt settlement: damages credit, increased collection calls, possibility of lawsuits, tax consequences and the need to settle with all creditors.
Tax consequences
Another common objection to debt settlement is that debtors whose debts are partially canceled outside the bankruptcy system will need to report the canceled portion of the debt as taxable income. (IRS Form 980)
The Internal Revenue Service considers $600 or more of forgiven debt as taxable income. The forgiving creditor must provide the taxpayer with a 1099-C tax form. This form will list the amount of forgiven debt and interest in Box 2. Taxpayers with portions of personal loans forgiven may not subtract the interest reported in Box 3 from the amount of reportable income on this form.
However, the IRS does not require taxpayers to report forgiven debt if the tax payer was insolvent at the time the creditor forgave the debt. Being insolvent means that the amount of a debtor’s debts are greater than his/her assets (how much money and property the debtor owns). However, the IRS adds that “you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent.”
For example, if a taxpayer is $10,000 in debt and owns $3,000 in assets, he/she cannot exclude more than $7,000 of forgiven debt from his/her income tax. Any forgiven debt over $7,000 that year must be reported as taxable income. |
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Debt Settlement Trade Associations |
Due to the rise of debt settlement as a debt relief alternative to bankruptcy, groups working in the industry have established trade associations to help secure industry standards that will protect consumers against unethical business practices. These trade associations were also established to lobby state governments because many state legislatures are passing laws that restrict out-of-state companies from providing debt negotiation services to in-state residents. The two major trade associations are the United States Organization for Bankruptcy Alternatives (USOBA) and The Association of Settlement Companies (TASC). Both of these organizations publish on their websites information about debt settlement and the debt settlement industry.
Individual Debt Settlement consultants can obtain thorough industry training and Certification through The International Association of Professional Debt Arbitrators. (IAPDA). |
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Our Featured Question & Answer of the Day For Monday
Q. What is the difference between a Debt Settlement Program and Debt Management Plan (DMP)?
A:
Debt Management
In a debt consolidation programs, also known as a Debt Management Plan (DMP), you pay back 100% of your debt plus interest. Interest is commonly reduced to the 8% to 10% range. Additionally, Most Debt Management Companies have a monthly service fee tacked on to your monthly payment. Most people pay back about 130% of their debt over 5 to 6 year period. Debt Management has a moderate affect on a good credit file and will improve most poor credit files.
Debt Settlement
In a Debt Settlement program, most pay back an average of 40-50% of their total debt, including all agency fees as well as accruing fees and interest. This 40-50% figure is based on your starting balances.
In some cases, where a client has very challenging creditors combined with a good income, liquid assets, etc., Certified Debt Specialists may end up with what they consider to be a less than perfect result and pay back may be in the 60% range. This is still a substantial savings for most clients and proves to be an effective program.
Also, the contrary is true. Certified Debt Specialists often are able to obtain total settlements including fees in the 40% range when the factors are just right.
Most clients are able to liquidate their debt in 2 to 3 years vs. 5 to 6 years in the DMP and the monthly payment is commonly smaller than a Debt Management Payment for the same debt.
Debt Settlement has a major impact on good credit but will improve credit for people that are 6 months or more past due. This improvement in credit profile is caused by bringing outstanding balances down to a ZERO balance. |
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