Debt Settlement Programs Flunk Out

Debt Settlement Programs

Debt settlement programs fail about 50% of the time.

People go into debt settlement plans because they feel ashamed about filing bankruptcy. But the failure rate for these plans is very high. A big reason for Debt settlement programs failing is because of the arithmetic behind them. The math used to calculate your payments in debt settlement programs often doesn’t add up. I’m going to show you why that is.

The concept behind debt settlement programs seems simple enough. You owe a bunch of money. You see a TV ad promising debt relief. The debt settlement programs offer you a way to stave off bill collectors while you save up money to fund your settlements.

Debt Settlement Programs Flunk OutI’ll tell you why these settlement programs fail. There are two reasons. The first reason for the failure of debt settlement programs is because creditors rarely work with the programs. Bill collectors have no legal duty to lay off of you, even after you have enrolled in a program. Debt collectors will normally stay on your tail. They will threaten you with lawsuits and wage garnishments, and they intend to carry out the threat.

The second reason is because of compounding interest. Debt settlement programs do not control the interest rate that each credit card is charging. And, the promoters of these bogus programs do not have any power to force the credit cards to stop the debt collections against you. Thus, the money you owe piles up at a faster rate than the money you are paying into the debt settlement programs.

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Debt settlement programs get crushed under the weight of compounding interest.

After you default on a credit card the interest rate usually balloons to around 30% APR, (annual percentage rate). The banks call this a “default” interest rate. Under default conditions, your interest rate could increase to as high as 31.99 percent, with the average penalty or default rate being 26.87 percent, according to a July 2008 study. In our debt settlement anatomy below, we will use an average credit card interest rate of 29% on delinquent accounts.

Debt settlements are a great deal for the outfits who offer them. They advertise miracle results, and charge you huge administrative fees. Unscrupulous credit counselors may push a client into debt settlement programs even when bankruptcy is clearly the best remedy.

As a Los Angeles Bankruptcy Lawyer, I have seen the shocking truth that debt settlements are simply a bad investment for the client in almost all cases, (discussed in Part One of this article).

Let’s rip apart some typical debt settlement programs and see how they rip you off.

Here are the typical elements that you are likely to encounter if you enter any debt settlement programs. I’m going to illustrate this with an example. Let’s use a typical case profile. It involves an individual who owes $30,000 on delinquent credit card debt. That person would like to reach settlements with creditors and avoid filing bankruptcy. The person in my example can afford monthly debt payments of $400 per month.

After you have suffered enough mental abuse from bill collectors you become receptive to to the advertising pitch offered by debt settlement programs. By now, you have seen enough debt settlement ads to finally call one of them for help. You call and talk to someone who seems like a compassionate, caring credit counselor.  Let’s follow through and see what happens.

The counselor will talk with you to determine a reasonable monthly amount that you can afford to pay towards your debts.  You have determined that the most you can afford to pay is $400 per month, and even that will be a struggle. The counselor tells you that $400 per month will handle $30,000 of delinquent credit card debt. The counselor assures you that the company enjoys special relationships with all of your creditors.

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Wake up. Your debt counselor is actually a salesperson.

You are also told that settlements are achieved many time for pennies on the dollar. But, that doesn’t always happen. Therefore, the counselor asks you to conservatively estimate that your debts will be settled for around 50 cents on the dollar. You breathe a sign of relief! You will then sign their contract via email or fax, agreeing to join their program. Most people don’t bother to read the fine print in the contract. The compassionate ‘counselor’ you were talking to is a actually sales representative, who was probably selling timeshares before taking this job. Legally speaking, anyone can call themselves a credit counselor. It takes no special training or knowledge, other than salesmanship.

You have been told that $400 per month is enough to handle your $30,000 of debt. You will pay that to them every month, into a special settlement account set up for you. When enough money is in the account, they will settle your debts. The monthly payment is deducted right out of your checking account each month. (It seems like most of these companies are in Florida or Texas. That may be because of lax regulation.) You are told to refer all debt collectors to them.

The fine print in debt settlement programs can cost you big money.

The fine print of the contract says, (but you fail to see), there is an up front “administrative fee” of $4500 that must be paid before the company ever begins to settle your debts. That means that for the next 11 months, your monthly payment is syphoned off as fees to the company, with not one dime ever paid out to your creditors. Oh, and there is another fee that you may or may not remember the counselor telling you about. You will be charged an administrative monthly fee of $19.95 as long as you remain in the program.

Debt settlement programs lead to widespread consumer disappointment.

After 5 or 6 months of participating in one of the debt settlement programs, you finally see that this is getting you nowhere. Not one dime has been paid to your creditors. Your creditors are getting very aggressive. They still call you relentlessly. Debt collectors are even threatening you with lawsuits and wage garnishments. The debt collectors tell you on the phone that they do not work with debt settlement programs. You are also told that if you don’t pay up now, the account will go to a lawyer for legal action against you.

The ‘not-so-smart’ consumers will hang in with the program, because they desperately want to believe what was told to them when they signed up for it. The ‘smart’ people usually drop out of the program at this point because they can finally see that they are simply being ripped off.

Let’s Do Some Arithmetic. I’ll show you mathematically why debt settlement programs are a complete rip off.

Debt Settlement ProgramsRemember that $30,000 of typical, delinquent credit card debt? As soon as it became delinquent, most banks jacked the interest rate up to 29%. Let’s see how effectively your $400 month debt settlement payment will fix this $30,000 debt problem. Let’s also assume that the banks will eventually settle these debts with you for just 40 cents on the dollar, even though 50% settlements are more typical. Lastly, let’s also assume that you owe six different debts, each totaling $5000, for a total debt of $30,000.

Your Debt Settlement Calculus. (Don’t worry. I have already done the math for you).

Let’s say you have faithfully paid $400 monthly for 11 months. The account balance in your debt settlement fund is at zero. That’s because the Program has taken all the money paid in so far as their ‘up front fee.’ Just as bad for you, the $30,000 amount of debt you had when you started the program almost one year ago has now grown to almost $40,000. That is because of the effect of compounding interest.

Unfortunately for you, each $5000 credit card now has a balance of about $6,600. However, you are still optimistic. You are still hoping to settle your accounts at 40%. To settle just the first of your six accounts, you need to have about  $2,666. However, you have $0.00 in your settlement fund.

How soon can you settle the first debt?

It will take 8 more months before you can make your first 40% settlement, (because interest still runs until the settlement is paid.) Thus, your first 40% debt settlement can be paid no earlier than 17 months after you started the program.

What’s the next step in the program?

You have paid off one of the six debts you started out with. Because of the effect of compounding interest, the balance you still owe on your other 5 debts has now grown to about $38,000, or $7,600 each. Before you can settle the next debt at 40%, you need $3,040 right now. But, your settlement fund has been depleted and it is back to $0.00. It will take some time to build up more cash. Your credit counselor urges you to be patient.

Paying off the 2nd credit card.

It will take 9 more months at $400 per month to pay off the second credit card. When you do, the remaining balance that you still owe on the other 4 debts has increased to about $37,000. It seems like the balance doesn’t change much, even though you have settled two out of six accounts. If it seems that way to you, you are right. The power of compounding interest is positively awesome. let’s assume again that you can settle the next debt at 40%.

However, each of your 4 remaining accounts has now grown to about $9250. You need another $3700 right now to settle the 3rd account at 40%. But, your settlement fund has been depleted and it is again back to $0.00.

Paying off the 3rd credit card will happen approximately 38 months after you started this program.

Your 3rd credit card account has a balance that has grown to approximately $9284. You will need about $3713 to pay 40% of it. The balance you owe on the remaining three credit cards has now grown, after 38 months, to about $37,000. This is spooky, isn’t it? That is the same amount you owed after you had paid off the 2nd account. (Are you starting to get the picture of what is going on here?) Each of the remaining three credit cards now has a balance due of about $12,333.  To settle the 4th credit card at that point will cost roughly $4933.

Paying off the 4th credit card.

That should be doable at around the 53rd month into your debt settlement plan, paying 40% of $12,333, for about $4933. Are you pleased with this program?

Paying off the 5th credit card. (This is unbelievable!)

You may not believe this, but by the time you settled your 4th credit card, at 54 months into your program, the amount you will still owe on the 5th card has now grown to about $15,731, ($5000 compounding at 29% for 54 months, and it is the exact same for the 6th credit card. You would need about $6300 right now to settle card number 5, but your account balance is back to zero. Some 16 months later, you have the $6300 that is needed to take out the 5th credit card.

Paying off the 6th and final credit card.

You paid off card number five at 70 months into the program. You should be able to settle the last remaining credit card when you arrive at about 112 months into your program. At that time, the current balance on the 6th card will be about $69,598. (The good news is that you are going to pay only 40% of that amount, which is only $27,830, so what are you complaining about?)

Congratulations! You have successfully completed your debt settlement program.

Let’s recap your accomplishment.

You started your debt settlement program 112 months ago with $30,000 of delinquent debt. You got your debts settled for just 40% of what you owed on them, based on the outstanding balance at the time of each settlement. Your total payments were $4500 for the up front administration fee, and about $51,149 in actual debts payments. You also need to take into account that monthly maintenance fee of $29.99 that you have been paying, which is another $2,234.

Your total cost has worked out to around $57,883, and it took more than Nine years! Maybe you should have filed bankruptcy?

Wouldn’t you feel awfully stupid if you had actually done this? Folks with money trouble are such an easy target for getting ripped off.  The settlement promoters play on your honest desire to pay the debts and save your credit. They promise you it is easy, affordable and allows you to avoid bankruptcy. This is almost always a lie, as you have seen.

The math side of this just doesn’t add up. Oh, and your credit, has that been saved? Of course not, like most everything else they promised you, that too is a lie.

Your credit will stay trashed for as long as you have delinquent, outstanding debt, plus an additional 7 years after you settle each particular account.

In our hypothetical example, we are talking about bad credit for the nine years it took to finish the program, plus another 7 years from the date you settled the final account: 16 years total on your credit!

Suppose that instead of doing a debt settlement program, you had filed bankruptcy. What would be different?

Money saved. If you discharged your debts in bankruptcy, you would have saved yourself $57,883 which was wasted in the debt settlement program.

Bad credit. The bankruptcy would drop off your credit after only 10 years, instead of the 16 years you must live with the mistake of having done a debt settlement program.

While your settlement program is chugging along, there is another side to the story. The side of your creditors. As far as they are concerned, you owe what you owe, and they don’t stop working to collect the money. They fully intend to continue calling and demanding money from you. Eventually, they will sue to collect their money, and you may face the prospect of a future wage garnishment. You will be charged interest on it every month until each debt is satisfied. They will not sit by idle waiting for you to complete your program. The fact is that aggressive debt collections will probably force you into bankruptcy before you ever settle a single debt.

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Leon Bayer and Jeffrey Wishman are Los Angeles Bankruptcy attorneys. They have been practicing bankruptcy lawyers in Los Angeles for 37 years and are Certified Bankruptcy Specialists by the State Bar of California. These are lawyers who bring experience, skill and creativity to the highly complex area of bankruptcy law. At this Los Angeles law firm, the your initial consultation with an expert is free. Mr. Bayer is a coauthor of Nolo's The New Bankruptcy: Will It Work for You?, authors the “Ask Leon” series on Nolo’s Bankruptcy, Debt & Foreclosure blog, and writes on bankruptcy topics for Nolo’s website. In addition, Mr. Bayer devotes a significant number of hours to volunteer legal services. The State Bar of California has commended Mr. Bayer for this work every year since 2004.