A recent client asked the following question:

“I am unable to make the payments on my credit card accounts due to my wife’s income dropping, and I am currently working with a debt relief company that negotiates with the credit card companies to reduce the amount I owe.  Unfortunately, I am having a hard time setting aside enough money to escrow for settling even the reduced amounts. I also recently learned that in most cases the IRS will tax me on the amount that is forgiven by the credit card companies, which negates some of the savings I would realize. I would like to know what the advantages of bankruptcy are over the method I am currently pursuing.”

I meet new clients every week with this exact same story.  They come see me when they have been sued despite the fact that they had hired some agency to settle the debts.

The facts are, most debt settlement programs do not work.  Why?  Because to settle debts you need cash in hand.  Almost every debt can be settled for less than what is owed, but you need cash to settle.

As a general rule, you need about one-third of what you owe in cash within 6 months of stopping payments to creditors to effectively settle debts.

Debt settlement companies advise that you stop paying all your credit cards and instead that you start paying them money into an “escrow account” so they can settle the debts.  The programs are really attractive since the settlement payment tends to be much lower than your current credit card minimum payments.   That’s the hook–it seems so much more affordable than your current plan.  The problem is, most of the negotiation plans are doomed from the start because there is not enough money saved in the settlement fund quickly enough to effectively settle the debts.

Here are some examples of debt settlement programs I have seen:

 Monthly  Income  Amount of Debt Monthly Debt Settlement Payment Funds Available in Six Months Percent of Debt Saved in 6 Months
                     2,495             74,178                         1,000                               6,000 8%
                     3,350             51,673                            942                               5,652 11%
                     2,200             17,500                            317                               1,902 11%
                     3,900             46,518                         1,078                               6,468 14%
                     2,900             36,712                            517                               3,104 8%
                     4,240             49,798                            740                               4,440 9%
                     1,200             24,434                            400                               2,400 10%
                     1,540             38,867                            868                               5,208 13%
                     2,800             31,222                            470                               2,820 9%
                     4,600           100,159                         1,539                               9,234 9%
                     4,000             96,313                         1,237                               7,422 8%
                     3,000             22,432                            499                               2,994 13%
                     3,300             84,498                            383                               2,298 3%

Do you see the problem here?  There is only about 10% of the debt balance saved in cash after six months of not paying creditors.  That is not enough to settle the debts.  You need about 33% of the debt balance in cash within six months of stopping payments to creditors in order to be able to effectively settle the debts.  10% is a joke.  The program seems like it is working at first because the agency has settled a few smaller balance accounts, but eventually you get sued and realize the program is not going to work.  The success rate of debt settlement programs is probably less than 10%.  It may be less than 5%, but the industry does not report this statistic so it is hard to estimate.

“The success rate of debt settlement programs is probably less than 10%.”

Tax Consequences of Debt Settlement.

There can be income tax consequences to debt settlement.  The credit card companies may send you IRS Form 1099-C: Cancellation of Debt for the amount you did not pay.  If you receive such a form, you will need to complete IRS form 982 on your tax return.  Here is a video on this topic.

Final Thoughts.

Does debt settlement work?  Yes, it works for some people, but not many in my opinion.  We settle debts for clients every day.  Debt settlement can be a smart way to avoid bankruptcy, but you need cash.  A lot of cash within 6 months.  If you can raise the cash this might be an option.  Instead of hiring an unknown company located in a distant state, contact a licensed attorney in Nebraska with experience in settling debts.

Have you tried debt settlement?  Share your experience here.

Image courtesy of Flickr and 401(k) 2012