How will you know if you are caught in a debt settlement trap?

To a person facing significant debt, debt settlement schemes can have a forbidden-fruit effect. The relief they claim to offer — such as full debt relief in a month — is almost too good to pass up. Yet, most consumers who take this route find the opposite of relief; they end up with even more debt.

The Federal Trade Commission, consumer bankruptcy attorneys and other professionals continue to see debt settlement companies promising what they cannot deliver to consumers, some creating outright fraud.

So how can you tell if you are the victim of a debt settlement trap? Here are some things to look for:

• You have been encouraged to default on your debts: Debt settlement companies will tell their clients to stop paying their monthly bills because creditors will often only negotiate with consumers behind on their debts. However, by defaulting, you may face fines, higher interest rates and even wage garnishment. Furthermore, after defaulting, many creditors will not settle with you, causing you to be much worse off than before.
• The debt settlement company is unable to work with all of your creditors: Even if one creditor agrees to settle, your other debts may expand quickly. The debt settlement industry admits that two thirds of their clients are unable to reach a settlement with their creditors.
• You face tax liability for your settled debts: Creditors might report you debt reduction to the IRS, which, if you have not gone through bankruptcy, will be considered income. In other words, you will need to pay taxes on the amount of debt excused by your creditors.

In reality, while some debt settlement companies are worse than others, debt settlement is usually not the best option for consumers. The very theory behind debt settlement requires you to breach your contracts with creditors. There are other options to relieve you of your debt burden. For example, Chapter 7 bankruptcy will allow you to keep much of your property while discharging your debts. If you do not qualify for Chapter 7, Chapter 13 bankruptcy will let you set up a 3- or 5-year repayment plan with your creditors.

Learn more by visiting our pages on Chapter 7 bankruptcy and Chapter 13 bankruptcy.

Source: NACBA, Consumer Alert, “The Debt Settlement Trap: The #1 Threat Facing Deeply Indebted Americans,” Oct. 2012.