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Friday, April 2, 2010

Should I Do Debt Settlement?

Should I Do Debt Settlement?

I get this question a lot. "Should I do debt settlement?"

The answer is easy: "Almost certainly not."

Why? Because there is almost always a better alternative.

The basic idea of debt settlement is simple: You stop paying your credit cards. You build up a "war chest" of funds. You offer the lure of funds to credit card companies to convince them to take less than the full amount of the balances. You hope that the credit card companies agree to the deal. After some number of years you end up debt-free. Sounds great, right?

There are three main problems.

Problem #1. Way too many debt settlement outfits are scams.

I don't want to paint with too broad a brush here, but the chances of your finding a debt settlement company that provides good value for the money that you pay them is extremely low. Debt settlement companies get very high fees and vary rarely deliver the kind of results that their clients expect. Clients routinely tell me that they have paid $10,000-20,000 to debt settlement companies and have barely made a dent in their total debt.

If you are going to try debt settlement, please use a local attorney. Don't use a random company that you saw on TV or found on the Internet. And don't use an attorney from out of state. If you use a local attorney, at least it will be easy for you to complain to your local bar association if things don't go well.

Problem #2. The debt forgiven is taxable as ordinary income.

This is usually the deal-breaker. If you can get the credit card company to take less than the amount of the balance, the amount of the reduction is taxable to you as ordinary income.

How does this work?

Suppose you have $50,000 in credit card. And suppose you manage to get the credit card companies to agree to 50% reduction. So now you owe only $25,000. The other $25,000 that you don't owe anymore, the IRS taxes that as if your employer just gave you a nice bonus. The credit card companies will send you a 1099 and you will have to report the debt forgiven as income on your tax returns.

For most folks, debt forgiveness just doesn't make sense when you take into account the tax effects.

Problem #3 The cost of debt settlement is crazy

Seriously, it blows my mind what clients tell me they have paid debt settlement companies. I routinely hear about fees of $4,000-5,000 before any payments go to the creditors.

For that price, and perhaps substantially less, most folks can do a chapter 7 or chapter 13 bankruptcy that probably will address all issues better than debt settlement would. There are very few people who would benefit more from debt settlement than a chapter 13 bankruptcy. Yet, for whatever reason many people think that debt settlement is a better option.

It very rarely is.

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