6 Ways Debt Settlement Can Leave You Deeper in Debt (Even With Trustworthy Companies)

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Late night TV ads and radio ads promise that you can obtain debt relief, paying "pennies on the dollar" for what you owe to creditors.

These ads are for debt settlement, a process designed to convince creditors to accept a lump sum payment for less than you owe them. Your account is closed and considered paid off, and you no longer have onerous debt payments. (Although the settlement might be noted in your credit report and impact your score.) (See also: Surprising Things That Can Kill Your Credit)

Unfortunately, debt settlement often comes with pitfalls that can cause you problems — even if you are dealing with a reputable company. According to a report from ResponsibleLending.org titled, "State of Lending: Debt Settlement," a debt settlement program can increase a successfully enrolled consumer's debt by 20% on average.

Here are six debt settlement realities that can cause you to end up with up with more debt, instead of less.

1. You Have to Stop Paying Your Debts

In most cases, debt settlement doesn't work unless the creditor thinks that you won't repay the debt without a settlement. If you are going to convince the creditor of this, you need to stop making payments on your debt.

Most debt settlement companies require you to make regular payments to them, instead of making payments to creditors. They keep the money in an account, and use the accumulated savings to make lump sum payments to creditors who agree to settle.

As you might imagine, this doesn't bode well for your credit score. Additionally, as you miss payments, fees and penalties (and interest) add up. If you can't reach a settlement with some of your creditors, you are in deeper through all the costs of missing payments and defaulting.

2. Some Creditors Won't Work With Debt Settlement Companies

Not all creditors are willing to work with debt settlement companies, so the fact that you aren't making payments becomes increasingly problematic as the process continues. The creditor, instead of settling your debt, might decide to send your account to collections. This move further dings your credit score, and adds to your debt through fees, penalties, and interest accruing on all of it. (See also: How a Solid Credit Score Saves You Money)

And, of course, as your credit score continues to drop, it's harder for you to get loans at good rates. You will continue to pay more money over time as a result of your destroyed credit — even for non-credit financial services like insurance.

3. Creditors Could Decide to Sue

In some cases, turning your account over to collections is the least of your worries. Creditors who don't negotiate with debt settlement companies might decide to sue you for what you owe instead of just turning over your debts. This can add to your debt, since you now have attorney fees and other costs related to the lawsuit.

4. You May Pay Hidden Debt Settlement Fees

The Federal Trade Commission says that debt settlement companies can't charge fees upfront. They are only supposed to charge a fee after a settlement is reached. However, there are loopholes to this rule, and debt settlement companies have no problem taking advantage.

In order to get around the FTC's requirement, many debt settlement companies claim they have attorneys working for them. They form very loose associations with willing attorneys, and then charge you an attorney fee. So, technically, it's not a fee for debt settlement; it's a fee for the attorney. However, the attorney doesn't actually do any of the work in most cases. The attorney gets a bit of a kickback, and most of the process is handled by non-attorney employees for the debt settlement company.

5. You'll Have to Pay Tax on the Settled Amount

Most consumers don't realize that forgiven debts are considered income by the IRS. So, if you owe $15,000 and you settle your debts for $8,000, the IRS requires you to report the $7,000 you were forgiven as income. You don't actually have the money in hand (it was spent a long time ago), but the IRS taxes you like you do.

Depending on how much you benefit from debt settlement, even a successful experience with a debt settlement company can result in costly tax debt. If you have a big enough settlement, you could wind up in a higher tax bracket. You might need to set up an IRS payment plan to deal with the problem, and that means more interest payments.

6. You May Still Have Bad Credit Habits

Finally, one of the problems with debt settlement is that it might not address your underlying issues with money. Sure, you might settle your debt, but once everything is taken care of, will you end up back in debt down the road?

Many consumers go through debt settlement, but do nothing to change their overall money habits. Once their credit recovers enough that they can qualify for credit again, they start accruing debt. Even if you have gone through debt settlement, it's possible to get a credit card again fairly easily. Debt settlement can also make the process of getting rid of debt feel easier. If you feel as though you've dodged a bullet, you might not have incentive to reform your financial habits for the long haul. You could easily end up back in debt — and looking to use debt settlement services again. (See also: 12 Habits of Highly Responsible Credit Card Users)

Bottom Line

There are some people who use debt settlement effectively, but the truth is that there are so many pitfalls that true success with this process is hard to come by. Instead, you are far more likely to end up with more debt than you started with.

This is especially true if you have mixed results. When you have some creditors accept the settlement, but others refuse, you end up with additional fees and interest — not to mention the extra tax liability from the accepted settlements. You might have to borrow just to deal with the aftermath of your debt settlement!

If you are considering debt settlement, carefully think through your options, and consider consulting a different financial professional who can help you put together a realistic plan for repaying your debts and reforming your overall finances.

Have you relied on a debt settlement firm to help you get out of debt? Please share your experience in comments!

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