Debt settlement: A costly escape

By SmartMoney

If you're drowning in unpaid bills and desperately looking for a way out, chances are you've come across an offer that sounds something like this: For a fee, a professional debt-settlement company will help rid you of your debt for as little as half the amount you owe.

Sounds like a scam? Or like you're finally getting the break you deserve?

The answer may surprise you. Debt settlement is, in fact, a perfectly legal solution for consumers who are in deep and seeking an alternative to bankruptcy. But having a debt-settlement company do the legwork for you is fraught with risk, not to mention outrageous fees.

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Here's what you need to know about debt settlement and the companies that claim to do it for you:

The basics

It's a little-known fact that when you fall further and further behind on your payments, creditors would much rather agree to settle your debts than have you file bankruptcy and not get paid at all, says debt expert Gerri Detweiler, author of "The Ultimate Credit Handbook."

In exchange for an agreed-upon one-time payment -- typically, between 20% and 75% of what you owe -- the creditor forgives the rest of your debt and starts reporting it to the credit bureaus as settled. Meanwhile, you'll need to put money aside toward the settlement and stop making payments to your creditors. On your credit reports, the balances of settled debts will show $0. However, any previous history of delinquent payments or charge-offs will remain on your report.

Not surprisingly, creditors don't like to advertise debt settlement. They also make it an extremely difficult solution to pursue. As a rule, creditors won't negotiate with consumers who are current on their bills, often refusing to discuss settlements unless you're at least three to six months behind, explains Detweiler. That means dodging collections calls while trying to save up the cash for a settlement.

If you're working with several creditors -- you'd typically tackle the debts one at a time as you collect the money to pay them off -- it's hard, if not impossible to know which creditor might agree to settle earlier than others. "There's an art to it," Detweiler notes.

The problem with debt-settlement companies

With that in mind, it would be great to have an experienced, knowledgeable debt-settlement company hold your hand through the process, right? Not really.

Once you sign up with a company, chances are you'll pay dearly for its services, says Deanne Loonin, a staff attorney with the National Consumer Law Center (NCLC) who has investigated the practices of debt-settlement companies.

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Outrageous fees

Just how much will you pay? Good luck finding that out.

"I've never seen a company that's given a straight answer," says Loonin. The industry's fees and fee structures are all over the place. Some companies charge a percentage of the total debt -- typically 15% or 18% -- that's paid before you start accumulating savings. Others charge a percentage of the debt savings -- usually 25% -- once you settle, plus an initial sign-up fee and monthly service charges. Then there are those that charge a flat monthly fee throughout the length of the program.

Even the industry admits figuring out the costs is a challenge. "I have seen every kind of (fee) model you can think of," says Jenna Keehnen, the executive director of the U.S. Organizations for Bankruptcy Alternatives (USOBA), an industry trade group. "It's very confusing."

Worse than confusing, it's prohibitively expensive, says Katie Porter, a professor of bankruptcy law at the University of Iowa. She recently came across an offer to settle $33,551 in debt that projected a $5,032 service fee that was to be paid in monthly installments. Only after the service fee was paid off, two years later, did the client actually start saving for the settlement.

"That $5,000 buys a substantial amount of attorney time," she says. "You can get a consumer (or bankruptcy) attorney to represent you and help with your debt problems for a lot less than that."

Questionable services

What does a debt-settlement company do for you? In theory, it's supposed to help you negotiate your debts. In practice though, that doesn't really happen, says Porter. During the two or more years that you're saving money -- typically in an escrow account that the debt-settlement company has access to -- the company does nothing but withdraw fees.

"A lot of consumers think they've taken care of the problem after contacting a company, but the reality is the debt-settlement company hasn't settled anything in the beginning," Porter says.

The companies also claim that they'll help you dodge collections calls. But referring collections calls to your debt-settlement company often backfires, says Leslie Linfield, the executive director at the Institute for Financial Literacy, an organization that provides pre-bankruptcy counseling.

"Many creditors, once they know a client is working with a debt-settlement company, will escalate the account," she notes. That means sending it to a collections agency sooner or even suing you. And when a creditor takes legal action, the debt-settlement companies drop the account: They don't have the right to give legal advice or represent you in court.

High dropout rates

While there's no independent research on the average success rate of debt-settlement programs, anecdotal evidence shows many consumers drop out before the company reaches a settlement with their creditors, Linfield says. "As you talk to bankruptcy attorneys you'll hear horror stories of clients who paid thousands of dollars to a company and they're still in the exact same place," she says.

Continued: Shut down by the FTC

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