Debt Settlements Are Usually a Bad Option For the Client

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What’s Wrong With Debt Settlements?

Part One of Two Parts:

Debt settlements are a great deal for the outfits who offer them, including lawyers. They advertise miracle results, charge you hefty up front fees, and have a lucrative contingency fee on the tail end that you have to pay.  Lawyers can make a lot more money doing settlements than doing someone’s bankruptcy case.  That helps explain why there is so much advertising done by lawyers and others promoting debt settlements. Never mind what is in the client’s best interests, and never mind that they usually never work out as promised.

Debt settlements are simply a bad deal for the client in almost all cases. There are very few clients that will benefit from doing debt settlements.  As lawyers practicing bankruptcy law in Los Angeles with more than 30 years of experience, our firm will provide debt settlement services, but only in that very rare instance where it provides a tangible benefit for our client.

As bankruptcy lawyers, we are often asked by clients if they should try doing debt settlements. It’s a valid question, and is why we tell our clients that it is usually a bad idea:

  • Income Taxes.  A big drawback of debt settlements is that some people will owe income taxes on the amount of debt that has been forgiven. Suppose someone owes $10,000 to a bank, and we get the bank to settle with our client for  just $4,000, forgiving $6,000. Some people might owe income taxes on the $6,000 of debt that has been forgiven.
  • More Tax Talk. The tax codes normally treat the amount of a forgiven debt as as if it was ordinary income, earned in the tax year that the debt was forgiven, and then assess income taxes on it. The philosophy behind this is that money you borrowed but don’t have to repay gives you the exact same financial benefit as if it was money that you actually earned. The tax mans always finds a reason to taketh from thee.
  • A Little Tax Loophole. There is a narrow exception to this rule. If the taxpayer can prove financial insovancy at the time of the debt forgiveness, taxes won’t be owed. Proving insolvancy to the IRS may be difficult. The IRS will look at the value of all your assets. Many people have home equity and retirement savings that the IRS will count as assets. You might feel broke, but on paper the value of your assets might be more than the amount of your debts, and thus you are financially solvant and not immune to the tax consequences of debt settlement.
  • Bad Credit. Debt settlement does not save your credit, and it does not restore good credit to people who already have bad credit. Having good credit means that you always pay the full amount you are supposed to pay, and you always pay it on time. In almost all cases, a lender will not compromise over a debt unless the debt is already seriouslydelinquent. Why would they give a discount to someone who always pays on time?  If you are current on the debt payment but want to get it settled for less than you owe, you probably won’t have any success. If you let your debt get delinquent to the point where a lender is willing to settle, you have ruined your credit. It may take many years for it come back, if ever. Paying less than the amount you owe to settle a debt gives you a lousy credit reputation, and your credit report may reflect that for the next 7 years.
  • Often, No Real Benefit Can be Achieved. You have to be a fool if you intentionally let good credit turn bad because you want to try and get debt settlements. Let’s say you owe $10,000 on a credit debt that is current and in good standing. You let it go delinquent for the next 12 months, hoping that things will get to the point where you can get a very favorable settlement. Six to twelve months of delinquency is about where the chances of a settlement become realistic. Most credit cards will immediately jump to 30% or more interest after the first month that  the card is in default, and there will also be accruing late fees every month, and there can also be over monthly limit fees tacked on. After one year, the debt will probably have grown to $18,000. If you then settle for 50%, you must pay the bank $9,000. You might also pay fees of $2000 to a lawyer or a debt settlement company, and perhaps you pay $1500 in income taxes on the amount of debt forgiveness.  To settle that $10,000 debt, you will probably spend  $12,500, and you ruined your credit.
  • No Easy Monthly Payments. Most lenders require payment in a lump sum when they settle with you. They usually will not settle at a discount and let you make monthly payments. They already had that arrangment with you, and it didn’t work. They do not want to go back to that. Cash on the barrelhead is the usual requirement for settlements. Many clients would rather do settlements with their creditors than file bankruptcy. However, unless they are ready to pay at least 50% cash immediately, they usually can not be helped.
  • Bankruptcy May Work Better, and No Tax Owed on Discharged Debts. Most clients who would like to make debt settlements are actually perfect candidates for bankruptcy. If you are insolvant, you won’t owe taxes on debt forgiveness, but you will be paying out a lot of money, often 50% of what you owe, sometimes less, but sometimes more. Why pay out that money and still have bad credit? Just tink to yourself the other things that you could do with that money. Under Federal tax law, you do not owe income tax on debts that you discharge in bankruptcy.
  • The Ideal Settlement Candidate. The ideal debt settlement candidate walks into our Los Angeles Bankruptcy Law Firm with debts that already have a longstanding delinquency, and has valuable assets that might be worth too much to protect in a bankruptcy case, perhaps money from a recent inheritance or some other windfall. Such people are few and far between. Most people with a serious debt problem will find their best solution by filing bankruptcy.

The promotors of settlements have made heavy investments in advertising. The money to be made off people with debt problems makes it in the promotor’s best interest to recommend settlements, even where bankruptcy was clearly the best remedy for the client.

End of Part 1.

Jump to  Part 2,  Anatomy of a Debt Settlement Scam