Here's How Debt Settlement Can Make Your Debt Worse

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The commercials, usually played on AM radio or late-night TV, promise an easy solution to your debt woes: Debt settlement companies say they can eliminate your debts in as little as two months or reduce the amount you owe by 65 percent, 75 percent, or 85 percent.

That sounds pretty great. But debt settlement isn't quite as simple as those commercials promise.

Working with debt settlement companies — firms that negotiate lower debt amounts with your creditors — comes with serious financial repercussions. And plenty can go wrong. Before you sign up for debt settlement, make sure you explore your other options.

A dangerous gamble

The biggest problem with debt settlement is that it's a gamble. You're gambling that the process will work and that your debts will either be eliminated or lowered. Unfortunately, there are no guarantees that this will actually happen.

And because of how debt settlement companies operate, you can cause severe damage to your credit while taking this bet. Say you are struggling to afford your monthly credit card payments and a host of large medical bills. You call a company specializing in debt settlement. That company will then tell you to stop making your payments to this creditor.

That sounds like terrible advice (because it is). The debt settlement company's goal here is to convince your creditors that there is no way you can afford to pay off your debt in full. But it often takes months for the settlement company to convince your creditors to lower your debt. Defaulting for that long ruins your credit.

At the same time, the debt settlement company will ask you to make regular payments to it, which the company will deposit in a savings account. During the time that you're not making payments to your creditors but you are making them to the debt settlement service, the company will negotiate with your creditors, hoping to reduce the amount you owe to each of them.

Once your creditors and your debt settlement company reach an agreement, the company will use the funds you've deposited to pay off the remainder of your debt, taking a cut as its own fee.

It doesn't always work

Unfortunately, debt settlement doesn't always work. A report by the Association of Debt Settlement Companies made to the Federal Trade Commission in 2007 reported that on average, only 45 percent to 50 percent of consumers complete a debt settlement program once they've started it. Many customers take actions that will hurt their credit scores only to gain no financial relief by doing so.

In 2010, the U.S. Government Accountability Office reported even lower rates, saying that less than 10 percent of consumers successfully complete a debt settlement program.

You could be charged high monthly fees

The National Foundation for Credit Counseling says that many debt settlement companies charge monthly fees for their services that can run as high as $89 a month. That's a lot of money for a service that might not reduce your debt significantly anyway.

You'll pay a lot even if your debts are reduced

Debt settlement companies typically charge their clients in one of two ways: They'll either charge a percentage of your total debt for their fee, or a percentage of the final debt amount that they negotiate.

Say you owe $70,000. If the company charges you 20 percent of your total debt, you'll pay $14,000 for their services. Maybe the debt settlement company reduces that $70,000 debt to $35,000. If the company charges, say, 20 percent of your final negotiated debt, you'd pay $7,000.

Obviously, it's better to work with a company that charges you a percentage of your settled debt. But even then, you'll be paying plenty for debt settlement.

Your credit score might crash

Debt settlement can devastate your credit score. Any time you pay a credit card bill more than 30 days late, for example, your credit score will fall by 100 points or more. If you deliberately do this while working with a debt settlement company, you will see your score plummet.

Your credit report will also list any debts that were settled. This is considered a negative on your report because your creditors were forced to accept less than what they were owed. This, understandably, might make creditors less excited to work with you in the future.

Often, debt settlement companies negotiate a debt that has already been charged off, meaning that the original creditor has given up on collecting it and has sold the debt to another creditor that then tries to get at least some money from you. Such debt will be listed as charged off on your report. This negative mark will remain on your credit report for seven years, and won't disappear just because you eventually settled the debt.

Alternatives

Fortunately, there are alternatives to debt settlement.

• If you have a high enough credit score, you can apply for a balance transfer credit card. Many of these cards have low or no interest for periods of at least a year — often longer. You will have to pay a balance transfer fee (usually 3 percent of your balance) and be very careful about finishing paying your balance before the introductory period ends and a new, much higher rate kicks in. But for some people, this option works. (See also: 6 Hidden Dangers of Balance Transfers)

• You can also check with your bank or peer-to-peer lenders to get a debt consolidation loan at a lower interest rate than you're paying now. But with these types of loans you'll also need a good credit score.

• If you don't have good credit, consider contacting your creditors directly to work out a repayment plan that fits your budget. Creditors are under no obligation to work with you, but many will as a way to eventually get the money that you owe them.

• You can also work with a nonprofit consumer credit counseling agency to craft a debt management plan (DMP). The counseling agency will negotiate with your creditors on your behalf, typically resulting in a 20 percent lower interest rate and a 50 percent lower monthly payment.

  You will usually have to close all of your credit card accounts while you're under the DMP, but the upside is that you will only have one payment to make and that's to the credit counseling agency. Closing your accounts will cause a temporary dip in your credit score, but a DMP is much less harmful overall to your credit than debt resettlement. You can find nonprofit credit counselors in your area through one of two associations: the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America (FCAA).

• As a last resort, you may consider bankruptcy. This is sometimes less damaging to your credit report than a debt settlement, though certain types of bankruptcy stay on your credit report for longer. Be sure you thoroughly assess the pros and cons of bankruptcy before taking this step.

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