5 Reasons to Avoid Debt-Settlement Firms

While other businesses struggle to stay afloat, the debt-settlement industry is flourishing.

After all, with a growing number of consumers struggling to pay their debts there's plenty of business to go around. “We’re seeing new companies get into the business every day,” says Robby Birnbaum, an attorney and member of the board of directors of the Association of Settlement Companies, or TASC, an industry group. TASC currently has about 150 members, but Birnbaum estimates there are 600 to 800 such companies nationwide.

For many cash-strapped consumers, debt settlement may seem like the only option -- short of declaring bankruptcy. In such cases, the consumer hires a debt-settlement company to negotiate a one-time payment -- usually totaling about 40% to 60% of their total debt -- that will be paid to their creditor. The creditor then forgives the remaining debt. While this tactic is perfectly legal, it can cost consumers dearly and, in many cases, leave them even deeper in debt.

Here are five things you need to know before hiring a debt settlement company.

Debt-settlement companies charge fees that often run into the thousands of dollars. Payment structures vary. Some companies charge 13% to 20% of the consumer’s total debt, which gets paid over the first 12 to 15 months, says Gail Cunningham, a spokeswoman for the National Foundation for Credit Counseling (NFCC), which represents nonprofit credit counseling agencies. Other companies charge up to 35% of a projected settlement amount. For someone with $50,000 in debt that’s as much as $10,000 in fees that need to be paid before the consumer can start paying off the settlement itself.

Most banks strongly oppose working with debt-settlement companies. The reason? Debt-settlement companies instruct clients to stop paying their bills in order to save for a future settlement. (The savings are deposited in a special account, from which the debt-settlement company withdraws its monthly fee.)

American Express says it only works with debt-settlement companies when the company sends a “cease and desist” letter forbidding AmEx to contact the consumer. “We really don’t think that there’s a service or benefit that a debt settlement company will offer our card members that they can’t receive directly from us,” says Desiree Fish, an AmEx spokeswoman.

Virginia O’Neill, a senior counsel at the American Bankers Association says its members are “aggressively working to reach accommodations with people [directly], particularly in this environment.”

TASC’s Birnbaum counters that “the banks happily accept millions of dollars from debt-settlement companies every week.”

If you decide to go the debt-settlement route, the odds are stacked against you. While debt-settlement companies don't release their completion rates, a look into the records of one organization -- the National Consumer Council, which the Federal Trade Commission sued for misleading advertising and shut down in 2004 -- paints a grim picture. Of the company’s 44,844 clients, only 638 (a meager 1.4%) successfully completed the debt-settlement program. Nearly half (43%) canceled after paying an average $1,780 in fees.

According to Birnbaum, about 30% of debt-settlement company clients leave the programs voluntarily. “A good number of consumers only want some of their debt settled, not all,” he says.

If you have too much debt, you may be better off filing for bankruptcy. Or, if you have too little debt to justify a settlement, then you'd probably do better with a debt-management plan, under which you pay off your balances in full at lower interest rates. However, don’t expect a debt-settlement company to advise you on which path is best. Because employees earn commissions, “you automatically create a situation where the sales rep will err on the side of bringing too many people,” says Charles Phelan, who coaches consumers on do-it-yourself debt settlement.

Since debt-settlement companies instruct consumers to stop paying their bills while they're saving for a settlement, their balances continue to swell with interest and late fees and their credit scores plummet. In order to get paid, creditors may even sue -- and these days, companies do that some time in the second year of nonpayment, says Phelan. With most debt-settlement plans taking 36 months or longer to complete, the chances of getting sued are pretty high.