I am often asked by clients if I can help them settle their debts with creditors. My answer is almost “yes” but it is rarely my recommendation that a client pursue debt settlement when there are bankruptcy options available. This is because in most cases, the credit ramifications of debt settlement are similar to bankruptcy. Also, most people don’t realize that any debt canceled by a creditor will be considered taxable income by the IRS whereas debt cancellation through bankruptcy is never a taxable event.
However, there are two situations in which debt settlement probably makes sense. First, if a client’s total debt is less than $5,000, then settling directly with creditors on reasonable terms is a smart option. In general, the client should aim for a settlement of about 50 cents on the dollar. Some creditors will settle for less and some will absolutely refuse to settle for less than 80 cents on the dollar (particularly when the creditor is a debt purchaser rather than the original creditor).
The second situation in which debt settlement is appropriate is when the client would be forced into a 100% chapter 13 bankruptcy plan (meaning that they would have to pay all creditors in full) either because of excess income or non-exempt assets. Clearly, it will cost the client less money to settle the debts rather to pay all creditors in full. However, this is easier said than done because creditors do not offer good discounts unless the client can make a lump sum payment. So, for example, if you have $20,000 in debt, you are going to need access to several thousand dollars if you want to settle all your debts at once or you are going to have to deal with one creditor at a time as you accumulate money.
If you do not have a good game plan for settling all the debts within a year or two, then debt settlement may not be a realistic option because your creditors are simply not going to wait much beyond that timeframe to get paid. Eventually, one of the creditors will sue you, obtain a judgment, and then garnish your wages if you are working. If this happens, it is very unlikely that you will be able to save money to fund settlements. Also, most debts carry such higher interest rates and penalties that a settlement reach two years down the road may not be much less expensive than full payment right away. For example, if you have a credit card balance of $1,000 today with an interest rate of 20%, then in two years, your balance will be $1,400 (plus late fees, over the limit fees, etc.). A 50% settlement will cost you at least $700, and don’t forget about the tax bill you will be getting for the $700 debt cancellation. Add the general stress that you will be under dealing with the debt for two years, and you can see why some clients simply prefer the assurance and peace of mind that comes with a court-supervised chapter 13 plan.
In our experience, debt settlement works best when you have an outside family member or friend who can loan or gift you the money necessary to pay off settlements quickly as they are reached. We have obtained great results for clients in these circumstances. If you would like advice about debt settlement and whether it is right for you, we encourage you to contact us. All clients receive a free consultation about bankruptcy and non-bankruptcy options that are available to them.