Liz Weston: Debt settlement a bad alternative to bankruptcy

Debt settlement isn't the Wild West industry it was a decade ago, when people routinely paid hefty upfront fees to companies that failed to deliver any relief.

Thanks to increased regulation and enforcement, the much smaller number of settlement companies that remain often do what they promise: persuade at least some of a borrower's creditors to forgive part of the debt, typically in exchange for a lump sum payment.

Several people I've interviewed lately reported positive experiences with debt settlement, so I decided to take another look at the industry. It turns out that hiring a negotiator could be a reasonable alternative to bankruptcy for some. But debt settlement is not as consumer-friendly as the industry presents it, and some of the people who praised the companies didn't fully understand their alternatives or the longer-term consequences of settling debt.

—One woman didn't realize she would face a tax bill on the forgiven debt.

—A man opted against bankruptcy in part because he erroneously thought he would lose personal possessions.

—Another woman was shocked at how far her credit scores tumbled and how much interest she was charged when she applied for a car loan.

WHERE DEBT SETTLEMENT FALLS SHORT

Here are some of the biggest problems with debt settlement:

—Negotiations can take years. Customers are told to stop paying their credit cards, loans and other debts and funnel money instead into a savings account. Freedom Financial Network, the largest debt settlement company, says half of its customers eventually settle at least 75 percent of their debt, but the process usually takes three to four years. Meanwhile, customers risk being sued over their debts, although Freedom says the percentage of its clients being sued is in the single digits.

—The math often doesn't work. Debts are normally settled for 45 percent to 50 percent of the current balance, which is often higher than the initial balance because of late fees and interest. The typical debt settlement fee is 20 percent of the debt at the time of enrollment. The amount of forgiven debt is usually reported to the IRS and is usually taxable as income. If the borrower is in the 25 percent federal tax bracket, the total cost of the settlement can equal 90 percent or more of the original amount owed.

—Many debt settlement companies unfairly demonize bankruptcy. National Debt Relief, another large debt settlement company, claims on its website, "Declaring Chapter 7 bankruptcy may mean saying goodbye to most of the assets that you've accumulated over the course of your life." In reality, few people who file for Chapter 7, which erases most debts in three to six months, lose any assets thanks to state laws that typically protect most if not all of what filers own.

Settlement companies also claim that bankruptcy is harder on credit scores. In reality, both processes often drop scores into the mid-500s, well into the "poor" range on the typical 300-to-850 credit score scale. Credit scores can begin to recover immediately after either process is complete. The difference, of course, is that Chapter 7 bankruptcy typically takes months, while debt settlement typically takes years. Plus, bankruptcy halts collections activity, including lawsuits, and can end wage garnishments.

"The one option that shines above all the rest is bankruptcy," says Steve Rhode, a former credit counselor who runs the Get Out of Debt Guy advice site. "It's the cheapest and fastest and the best way to rebuild your credit."

WHEN DOES DEBT SETTLEMENT MAKE SENSE?

Neither debt settlement nor bankruptcy is a good option for people who can pay their bills. Those who want to lower their interest rates can refinance with a personal loan if they have decent credit or sign up with a nonprofit credit counselor's debt management plan if they don't.

So when might debt settlement make sense? When your debt is unmanageable and you can't or won't file for Chapter 7 bankruptcy. If your only bankruptcy option is a Chapter 13 payment plan, which typically requires five years of payments before any remaining balances are erased, settlement could resolve your debts a bit faster so you can begin to build credit again.

People should research their alternatives carefully and not rely on what one debt relief provider tells them about the others, Rhode warns. Only bankruptcy attorneys are required to put their clients' interests first; other debt relief providers aren't required to tell you if other options might work better.

"Credit counselors hate debt settlement companies, debt settlement companies hate bankruptcy attorneys, and bankruptcy attorneys hate everybody," he says. "People need to go through and compare the options."

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This column was provided to The Associated Press by the personal finance website NerdWallet.

Liz Weston is a columnist at NerdWallet, a certified financial planner and author of "Your Credit Score." Email: lweston@nerdwallet.com. Twitter: @lizweston.