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Why Debt Settlement May Hurt Consumers More than It Helps

“Be debt-free in 36 months!”

“Reduce your debt by up to 50%!”

We’ve all heard commercials from debt settlement companies that use pitches like these, promising troubled borrowers that they can get out of debt by paying just a fraction of what they owe.  The industry that the New York City Department of Consumer Affairs once called the “top fraud of the year” is now fighting hard to set up shop in additional states across the country. While several states—such as New Jersey, New Mexico, Arkansas and Wyoming —do not currently authorize debt settlement, industry lobbyists have been making the rounds in state capitals trying to rustle up support to allow the practice.

But it may be in consumers’ best interest to keep debt settlement companies at bay. A recent report by the Center for Responsible Lending confirms that debt settlement is often not worth the risk—and leaves many consumers even worse off.
Debt settlement seems like a viable alternative for families struggling to break free from excessive debt. Enlisting the services of a professional to negotiate down debts appears equivalent to hiring a lawyer to deal with complex legal proceedings.

But there’s a catch. In order to sign up for debt settlement, clients must first default on all of their debts. The money they once spent on minimum credit card or other debt payments is then instead used to fund a special account that can eventually be used for settlements.[1] While consumers wait for settlements that may never come, their debts continue to grow due to late fees and other default charges.

In some cases, creditors simply refuse to negotiate with debt settlement firms. Clients face the significant risk that creditors may instead sue them to collect on these defaulted debts. For example, a Maryland regulator found that one in four clients had been suedby at least one of their creditors during the first year of their debt settlement program.

These drawbacks led the Federal Trade Commission in 2010 to bar debt settlement companies from charging fees until they had settled at least one debt on behalf of their clients. But the CRL report shows that while this regulation may have led to some improvements in business practices, serious risks remain for debt settlement clients.

A debt settlement company would have to settle at least two-thirds of a client’s debt in order for her to emerge better off from the process than when she started, according to the CRL’s analysis of data published by the industry trade association, the American Fair Credit Council. If the potential tax liability on settled debts and the monthly cost of maintaining a special account for settlements are considered, a debt settlement company would have to settle over 80% of a client’s debts for the savings to exceed the costs of the settlement process.

Historically, only a small portion of clients have achieved such successful outcomes. In 2010, the industry reported that over 42% of clients were unable to have even a single debt settled

More recently, the Colorado Attorney General reported that over half of clients in that state who enrolled in debt settlement programs in 2011 had dropped out of their programs by the end of 2012. During that same time period, fewer than 8% had all of their debt settled.

While there are exceptions, it’s clear that debt settlement is inherently risky for financially vulnerable families, potentially leaving many people much worse off than they were in the first place.

Any state should think twice before offering a welcome mat to the industry—unless and until debt settlement companies can show that clients typically settle enough debt to actually benefit from these programs.

The debt settlement chapter of the Center for Responsible Lending’s State of Lending series is available on the CRL website. Ellen Harnick is senior policy counsel and Leslie Parrish is deputy director of research at CRL.

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