The truth about credit repair services and debt settlement plans

July 6, 2018 - 6 min read

In this article:

If you’re having financial problems, you may be solicited by credit repair services or companies to settle your debts for “pennies on the dollar.” It is possible, but unlikely. The costs are high and there are better options.

  • You can’t remove derogatory history from credit reports if it’s true — only if it’s in error
  • Debt settlement is risky because it may not work; you could end up in court and your credit ruined
  • Reputable non-profit credit counselors, debt management plans and law firms can provide real help

You can remove inaccurate information from credit reports yourself, or your mortgage lender can help with a “rapid re-score” service. And reputable non-profit credit counselors can help with debt management and advice.

How debt settlement works

Debt settlement works like this:

  1. You stop paying your creditor(s)
  2. You give the money you’d spend making your payments to a debt settlement firm
  3. When you have saved approximately half of your outstanding balance(s), the firm will contact your creditor(s)
  4. They negotiate a lump sum payment to settle your debt and zero your balance
  5. You pay the debt settlement company; typically this is 20 percent of what you save

If you owed $10,000, for example, you’d pay $5,000 to settle your debt, and $1,000 to the debt settlement firm. But you’ll owe taxes on the $4,000 that your creditors write off.

What can go wrong with debt settlement

Debt settlement is a minefield you must navigate carefully.

A disreputable company may run off with your money and provide no services

A bad company might take your payments and not provide any services. This has happened often enough that the Federal Trade Commission (FTC) cautions consumers about choosing a service very carefully.

"Before you do business with any debt relief service, check it out with your state Attorney General and local consumer protection agency. They can tell you if any consumer complaints are on file about the firm you're considering doing business with. Ask your state Attorney General if the company is required to be licensed to work in your state and, if so, whether it is." 

Your creditors will contact you constantly and insistently for payment

Your creditors will step up their payment requests and may refer your account to a collection agency. While the law prohibits some aggressive behaviors, like threatening jail, showing up at your workplace or calling late at night, you’ll still likely be deluged with phone and mail demands for payment.

Over the months it will probably take for you to put aside the required funds, this can drive you crazy. High-stress levels are unhealthy and bad for your relationship with your family or significant other.

Your credit will be trashed

Every late payment — 30, 60, 90 days and longer — will cause your FICO score to fall like a rock thrown off a cliff. And even if you settle successfully, the creditor will add a code to your credit history, stating that you settled the debt for “less than the amount owed,” which also delivers a major hit to your score.

Your accounts will be closed and you will not be eligible for decent interest rates and terms for a very long time. Between the late payments and the ding for not paying your account in full, it can take years to recover from the debt settlement process.

You could be sued

To your creditors, debt settlement is optional. They don’t have to do it. And if they have any reason to believe that you are not destitute, the odds are they will sue you. In that case, you have a judgment against you, which can hurt everything from your credit score to your job prospects.

In addition, not only will you be responsible for the full outstanding balance, you’ll also have court costs and attorneys fees. Look at the fine print of your credit card agreement. It probably says something to that effect.

You’ll owe the IRS

Anything your creditor write off is considered income to you by the IRS. If you’re in the 25 percent bracket, you’ll owe $250 for every $1,000 you save. And if you don’t have it, you’ll have another creditor — the IRS. And the agency is a much more powerful creditor than any credit card company. This debt cannot be walked away from.

So, if we look again at the numbers in the example, your savings is actually small, considering the cost and the aggravation involved:

  • You owe $10,000
  • You settle for $5,000
  • The settlement company gets $1,000
  • You owe the IRS $1,250

So instead of paying $10,000, you’ll be out $7,250. That’s not exactly the “pennies on the dollar” these companies advertise. And you are taking on a huge risk.

What is credit repair?

Credit repair services cannot legally do anything that you can’t do yourself. They, and you can contact creditors and credit bureaus to fix inaccurate information on your credit reports.

  • You cannot eliminate correct information
  • Applying for a new tax ID or Social Security number to dodge a sketchy credit history is illegal
  • Purchasing “trade lines” or authorized user accounts is very expensive, doesn’t work well and is fraudulent
  • Many of these firms just dispute every ding on your report and hope the creditor doesn’t confirm it

Unfortunately, the only reliable form of credit repair is asking credit bureaus and creditors to erase inaccurate data, and paying your bills on time for months or years.

Alternatives to debt settlement

There are reputable alternatives to debt settlement that can better solve your problem. Here they are, from least to most drastic.

Credit counseling

A reputable non-profit credit counselor can help you learn to budget and put you on a plan to pay down your debts the old-fashioned way.

Credit counselors offer free educational materials and workshops. They should be certified and trained in consumer credit, money and debt management, and budgeting. Your counselor will go over your financial situation with you and help you develop a personalized plan to deal with your money problems.

Your first counseling session usually takes an hour, and you may schedule follow-up sessions.

Avoid companies that charge more than a nominal fee or give you a high-pressure pitch. You can learn if a credit counseling agency has consumer complaints filed by checking with your state Attorney General and local consumer protection agency.

The United States Trustee Program also keeps a list of credit counseling agencies approved to provide pre-bankruptcy counseling. You can probably trust them to help you, too. Agencies that are members of the National Foundation for Credit Counseling have to adhere to a code of ethics and are likely to be reliable.

Debt management plans (DMPs)

Your counselor may be able to work with your creditors to reduce penalties and even your interest rates. If you need more help, your counselor may recommend a debt management plan (DMP).

A DMP combines your unsecured debts, like credit cards. You make a single payment into the plan, and it, in turn, pays your creditors. In most cases, your interest rate and/or payment is lowered to make it more affordable.

It is very important that you choose a reputable company because you will be paying money to it and trusting that it will pay your debts.

If you can’t pay off your debts within five years with a DMP, you may need to go bigger.

Chapter 13 bankruptcy

Chapter 13 is very similar to a DMP. However, under Chapter 13, your creditors don’t have any choice about participating. A bankruptcy court determines what you can afford to pay each month.

You make the payment to the court, and it, in turn, pays your creditors. In this case, you may actually pay pennies on the dollar. After 5 years (3 years in some states), any unpaid amounts are written off, and you have a clean slate.

If you don’t have the income to make payments in a Chapter 13 plan, you may qualify for a liquidation and the total wiping out of all eligible debts.

Chapter 7 bankruptcy

Chapter 7 bankruptcy is only available to those who pass a “means test” and can’t be reasonably expected to make payments to their creditors. Instead, your non-exempt assets are sold and the money paid to your creditors. Any unpaid amounts get written off.

It’s a drastic solution that will affect your credit rating for many years. But for some, it’s the only option.

Alternative to credit repair

If you are applying for a mortgage, and there is inaccurate information on your credit report, your lender can help you remove it fast. That’s called a “rapid re-score.”

Rapid re-scoring companies only work with lenders, not consumers. You’ll need to supply proof that an entry on your credit history is inaccurate. For example, a copy of a canceled check showing that you paid a bill on time but it was reported as late.

Res-scoring usually costs less than $100 (in many cases $20 to $50) and your report is cleaned up in about 48 hours.

Just say no to bad debt settlement or credit repair ideas

With so many less risky and less costly options, don’t fall prey to hard-charging sales pitches and too-good-to-be-true advertising.

There are good options here for those who need real help.

Gina Freeman
Authored By: Gina Freeman

The Mortgage Reports contributor

With more than 10 years in the mortgage industry, and another 10 years writing about it, Gina Freeman brings a wealth of knowledge to The Mortgage Reports as its Associate Editor. Gina works with a team of world-class real estate and finance writers to bring timely and helpful news and advice to the audience. Her specialty is helping consumers understand complex and intimidating topics.