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In a rush to reduce debt? Take time to study optionsIf you're overburdened with debt, you know you're vulnerable – to the embarrassment of having your credit card declined at the grocery store, and to the next unexpected bill that could send you into bankruptcy.
You're also vulnerable to consumer pitches that tout an easy way out of your situation but may cause more harm than good.
For most people, the best solution to debt problems is to cut spending and chop up the credit cards. But if you're so desperate that you're considering other solutions, then you need to understand the difference between debt consolidation, debt management and debt settlement.
Each one is something you can do yourself, but companies offer their services to help you – for sometimes substantial fees.
Debt consolidation means putting all your debts into one account, to make it easier to deal with. Many people use a home equity loan to achieve this, but that can be expensive and can put your home at risk if you can't make the payments.
Debt management usually involves hiring a credit-counseling firm to set up a payment plan and help you follow it.
Debt settlement – also known as debt negotiation – is the most aggressive approach, and it's one step short of filing for bankruptcy. A debt settlement agency negotiates with your creditors to settle the debt for a lower amount than owed, much as a bankruptcy court does.
The problem is, sometimes clients of these debt settlement outfits don't fully understand what they're getting into.
Last week, Texas Attorney General Greg Abbott announced that a Dallas-based debt settlement company would refund fees to consumers who complained that the company gave confusing or misleading information about its 15 percent fees and the services it offered.
In a voluntary compliance agreement, DebtXS LP agreed to halt advertising deemed deceptive. It admitted no wrongdoing.
DebtXS case
According to the attorney general's office, DebtXS required consumers to place the money they would have paid to creditors into a personal savings account for several months. But not paying their creditors triggered aggressive debt collection efforts and even lawsuits. DebtXS misled some consumers into thinking it would hold debt collectors at bay during this period and prevent any litigation, the attorney general's office says.
After several months, DebtXS would contact creditors and offer to pay off the debt at a fraction of the balance owed. Creditors will usually settle for less than owed when the debtor is under serious financial strain because if the debtor files for bankruptcy, then the creditor gets nothing.
But some DebtXS clients found that creditors didn't agree to the lower payments, and they were still liable for the new, higher balance, the attorney general's office says.
Some clients had good experiences, but others also say they didn't understand how badly their credit scores would be affected.
After such a negotiated debt is settled, the creditor will report to the credit bureaus that the debt has been "paid," "settled" or "settled for less than full amount."
"That's not the same thing as a complete payoff of the debt in a timely manner," says Bettye Banks, senior vice president of education at Consumer Credit Counseling Service of Greater Dallas. "It's still a negative."
Another thing debt-settlement clients must realize is that forgiven debt is considered taxable income, so you owe income tax on the amount of the write-off.
For example, if you owe your credit card company $5,000 and it settles with you for $2,000, you'll have to pay tax on the $3,000 written off. You will receive a tax form reflecting the income, and a copy goes to the Internal Revenue Service.
Debt management
By contrast, debt management programs don't try to reduce the debt but only help you repay it.
In a management program, you deposit money each month with a credit counseling firm, which uses your deposits to pay your debts according to a payment schedule the counselor develops with you and your creditors.
Your creditors may agree to lower your interest rates or waive certain fees, but you should check with all your creditors to be sure they offer the concessions that a credit counseling organization describes to you.
A successful debt management program requires you to make regular, timely payments and could take four years or more to complete.
Ask the credit counselor to estimate how long it will take for you to complete the plan. You most likely will have to agree not to apply for – or use – any additional credit while you're participating in the plan.
"A DMP alone is not credit counseling, and DMPs are not for everyone," the Federal Trade Commission says on its Web site. "Consider signing on for one of these plans only after a certified credit counselor has spent time thoroughly reviewing your financial situation, and has offered you customized advice on managing your money."
Do your homework
If you think the more aggressive debt settlement approach is what you need, Texas Attorney General Abbott and other experts offer these tips:
•Learn about the legal consequences of stopping payments to creditors.
•Be wary of companies that guarantee results and promise you that your credit will not be negatively affected. Creditors decide whether to report a consumer's failure to pay bills on time to credit bureaus, and debt settlement companies have no sway in these decisions.
"Anything other than an on-time orderly payment is an anomaly, and any anomaly is bad," says Ms. Banks of Consumer Credit Counseling.
•Demand to know in advance all fees a debt settlement company will charge you for its services, above and beyond amounts to be paid to creditors, and get this in writing.
"The fees can just be outrageous," says Howard Marc Spector, a consumer bankruptcy attorney in Dallas. "Many paid nonrefundable amounts of money upfront, and if they don't make their payments, you don't get your initial deposit or anything you paid in, even if they haven't dispersed it."
•Be wary of advice to not contact your creditors. Not every creditor will go for a debt settlement or work with a debt settlement firm.
"Most card issuers prefer to work directly with their customers before things get too bad, and they will work out deals to pay it, depending on their individual situation," says Tracey Mills, spokeswoman for the American Bankers Association.
If you think you won't be able to pay your credit card bill, call the issuer as soon as possible.
"Once that debt is purchased by somebody else, you may be limited to what that particular collection agency is willing to accept," Ms. Mills says.
Pamela Yip
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