Is Debt Settlement a Good Idea?

Creditors are calling you every day, you dread going to the mailbox because of what you may find, and you're losing sleep at night trying to figure out how you'll pay off all of your debt. Then you hear of a company that claims to do battle with the creditors on your behalf, often settling debts for a fraction of what you owe. It sounds like a dream come true.

But there's a catch. Settling your debts can hurt your credit score, and it may be more costly than you realize. Here are a few things you should know about debt settlement before you do it.

How debt settlement works

Debt settlement companies negotiate with creditors on your behalf. They typically advise you to stop paying or communicating with your creditors and instead ask that you send a monthly payment to the settlement company instead. That money is held in an account until they have enough to settle your debts. Then they will use it to pay the creditors.

Your debts can be settled for much less than what you owe, but there are some unintended consequences to this approach.

Drawbacks of debt settlement

First, it can take months for a debt settlement company to negotiate with your creditors, and they can't do anything to stop the collectors from calling or sending past-due notices. Plus, if you do what the company says and stop paying your creditors, they will tack on late-payment fees and report your missed payments to the credit bureaus, which will lower your credit score.

Even if the debt settlement works, your credit score will likely still take a hit. The payment will likely be listed on your credit report as "settlement accepted" or something similar. This tells others who are looking at your report that you weren't able to pay the full balance you owed, and this may make new creditors hesitant to lend you money in case you can't pay them back either.

Another thing debt settlement companies don't tell you is that they charge a handsome fee for their services. The Federal Trade Commission's 2010 Telemarketing Sales Rule prevents these companies from charging up-front fees -- that is, taking a cut themselves before they settle your debts. But once that's done, they'll take anywhere from 15% to 25% of your total debt for themselves. So if you owe $10,000 and the debt settlement company charges a 25% fee, you'll end up paying the debt settlement company $2,500 for its services.

Then there's the fact that you could end up being taxed on the forgiven amount. If you were to settle your $10,000 debt for $3,000, for example, the remaining $7,000 might be added to your taxable income for the year, and you could end up owing the government more than you anticipated.

Debt settlement alternatives

Paying a debt settlement company isn't the only way to get rid of your debt. You can try negotiating the debts with the creditors yourself. That way, you don't have to pay the debt settlement company's fees, and you won't have late payments stacking up on your credit report. Negotiate with the creditor to see how much they would be willing to accept. Or come up with a payment plan that suits you both. Make sure you get a copy of the agreement in writing before you pay anything, and get a receipt afterward stating that your debt has been settled.

If you don't want to do that, you could always try enrolling in a debt-management program with a credit counseling service. These are usually nonprofit organizations that will work with you and your creditors to come up with a payment plan that won't hurt your credit score.

Bankruptcy is another option, although this should be a last resort. Bankruptcies will likely have a worse impact on your credit score than a settled debt, and they stay on your credit report for 10 years. However, bankruptcy can help you to get rid of most, if not all, of your debt, so it may be worth considering if your credit is already bad and nothing else will do.

Debt settlement can seem like a godsend, but it often causes just as many problems as it solves. It's best to stay away from this option if you can. But if you're determined to give debt settlement a try, make sure you choose a reputable company. Look for one that has a good rating from the Better Business Bureau and preferably one that offers a free consultation. Ask lots of questions and get a copy of their fees so you know exactly what you're getting into before you hand over any money.