People do not like to file bankruptcy, and most people explore any alternative possible before calling on a bankruptcy attorney. Many times, people contact me seeking “debt settlement” or “debt restructure.” It sounds better than bankruptcy and for a very small number of people with debt, it might be an alternative worth exploring. But like many things, the devil is in the details. There are some myths and misconceptions about debt settlement that consumers need to know about.
Myth: Settling debt will “look better” than bankruptcy
Fact: Not so much. Assuming a debt is paid for less than what was contracted for in the promissory note or credit card agreement, creditors are permitted to report the account as “settled”, which can be a derogatory remark on the credit report. This is not the same thing as “paid as agreed” or “paid in full.” Payments for less than contracted for may result in a negative entry on the credit report.
Myth: Settling debt is cheaper
Fact: Again, not so much. Most creditors offering settlements – and most companies out there who offer settlement programs – do not tell consumers that there are taxes that may come due as a result of the settlement. Creditors are allowed, in most circumstances, to issue a Form 1099-C for the amount of the debt that was “forgiven.” In other words, the amount of money that was actually “saved” is going to be taxable income.
The problem arises because not only are consumers not told this fact, but it is not uncommon for a consumer to not receive the Form 1099-C, even though it is filed with the IRS. The consumer only learns of a problem a few years down the road when the IRS sends the consumer/taxpayer a notice identifying underreported income. The notice will also seek the taxes, and the penalties.
Additionally, companies offering debt settlement will often charge a fee based on the amount they “save” the debtor. This is usually measured as the difference between the amount the creditor says is due, and the amount actually paid as a settlement. This further erodes any true savings.
Here’s an illustration: A consumer with $15,000 in credit card debt, using a company offering “debt settlement”, secures an agreement: One lump sum payment of $5,000 and the debt is “settled.” Taxes will need to be paid on the $10,000 “saved” – and for this example, let’s assume that it’s 30%. Plus, the fees due the company who secured the “savings” gets a percentage of 15% of the “amount saved.” So the debt for $15,000 ultimately costs almost $10,000 to resolve.
Myth: Debt settlement companies will help you get out of debt faster.
Fact: In most cases, you will end up in bankruptcy anyway. Many debt settlement companies are little more than parasites – offering “counseling” and “debt help” to people while taking the consumer’s money and not doing a thing. How do I know? Many of them have ended up being my clients.
If you’re contemplating “debt settlement”, read the fine print on the company offering it. In many cases, they will tell you to stop paying your bills while you make monthly payments. The monthly payments go into a bank account, which is usually in the consumer’s name, but the consumer has no direct access to it.
The debt settlement company will not try and settle debts with creditors until a sufficient balance is in the account. In other words, when there is enough money in the bank account to make negotiations worthwhile, then they start discussing settlement. Meanwhile, the accounts get sent to collection, the phone incessantly rings, and lawsuits get filed against the consumer. By that time, creditors are not in the settling mood.
What’s worse is that the fees charged by these companies is obscene – especially since they perform little to no service. Many companies charge a monthly payment – such as a percentage which is deducted from the monthly payment. Companies may also charge two months of payments, which are payable at the beginning of the “debt settlement program.” Thus, consumers do not actually start making any progress on debt resolution until they are poorer by two months payments (which in many cases, is when the phone starts ringing).
When the consumer gives up, trying to get the money back can be a hassle….and particularly painful, since in many cases, consumers are realizing they have been taken.
Myth: Anyone can benefit from settling debt.
Fact: Debt settlement can work for those consumers who have (1) sufficient income or assets to pay the settlement payment as well as the fees and taxes; and (2) are not so burdened by the debt (or by other debt) that settlement would be counter-productive.
For example: A homeowner making $50,000 per year and facing only $5,000 in debt might benefit from settlement since there may be income and/or home equity available to pay the settlement amount, and mortgage interest deductions might off-set any potential negative tax ramifications….this assumes, of course, that there is cash on hand to pay the settlement amount. However, if that same homeowner has little to no equity in a depressed real estate market, is concerned about future employment and income, and the debt is 25, 30 or even more than 50 percent of gross income, debt settlement might end up being counter productive.
A consumer contemplating debt settlement should talk to a debt settlement company and get all the details of the programs offered. Then, the consumer should take those details – along with all of their financial information – to a bankruptcy attorney who can give competent counsel based on the consumer’s individual situation. No respectable bankruptcy attorney is going to lead a consumer to bankruptcy when there are more suitable and productive options available.
Simply stated, the same cannot be said for many of these debt settlement companies. One of the more infamous is AmeriDebt and its related companies who bilked thousands of dollars from debtors who in most cases, just wanted to do what they though was the right thing. Sadly, in my experience, many who tried these companies without first seeking legal counsel ended up poorer, and in bankruptcy anyway….after months, and even years of struggling. The fact is, these companies prey on people who are under pressure with unmanageable debt. They are adept at offering hope to people who find themselves in what they believe is a hopeless situation. Any consumer who thinks that a debt settlement program is too good to be true would be wise to consult with legal counsel to see if it is indeed the case.
Lessons in Loan Modifications
Suze Orman is growing on me. Sort of. She often has sage advice for consumers, and lately she has been making regular appearances on CNN’s Larry King Live. I cannot say I completely agree with everything she says, but lately, she has been telling it like it is and when it comes to financial news and advice, it’s refreshing to see some honestly on TV. I have her suggest to consumers that if they are having problems with their mortgage, they should contact their lender (i.e., the workout or the loss mitigation department). A client recently told me he did just that, after hearing Orman suggest it sometime last year. He was falling behind on his mortgage, and decided to walk into his local bank to talk to them. It did not go quite the way he planned.
At the time, the client was not residing in Massachusetts, and his lender was a local bank. He sat down with the manager and explained his situation. Instead of extending an accommodation, or working with the client to help him keep his home, the manager basically said this: “sorry, but we have a lot of loans going delinquent and we need to cut our losses, so we’re going to start the foreclosure process now.” And so they did. The bank pretty much put the house into an accelerated foreclosure process.
Yikes.
That’s lesson number one: don’t go telling your lender that you’re having problems paying your mortgage unless you have some reasonable expectation as to what the response will be.
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Tags: American Bankruptcy Institute, Commentary - Legal, Modifications and Workouts, Mortgages and Foreclosures, Suze Orman
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