Debt settlement vs. credit counseling: What’s the difference?
Debt settlement and credit counseling basics
- Debt settlement companies charge a fee to negotiate a reduction in overall debt.
- Be wary of companies that employ tactics that can risk your credit standing.
- Credit counseling companies negotiate a reduction in interest rates and monthly payments debt, but not the principal.
- Credit counselors sometimes charge fees to set up and oversee payment plans.
Fee-based debt-settlement companies commonly buy television and radio time promising to free overwhelmed borrowers from crushing debts. The promise is that the company will negotiate with the creditors to knock off a big chunk, or even all, of the money a debtor owes.
During the last downturn, such companies sprouted up across the country. Some are legitimate law firms and companies trained to negotiate with creditors. In other cases, according to a 2010 U.S. Government Accountability Office study, the programs are scams.
Almost all of these debt-settlement companies, however, employ strategies to reduce debts that should come with a warning label, according to consumer advocates.
The Consumer Financial Protection Bureau (CFPB) says individuals should always be wary of for-profit debt-settlement companies that charges fees to reduce debts.
Pitfalls of debt settlement
The CFPB says many creditors have preset policies that determine how much debt they will forgive. So the debt-settlement companies will normally do no better than consumers negotiating on their own. Most debt-settlement companies charge a hefty fee calculated as a percentage of the amount of debt that has been extinguished.
The often-adversarial tactics of debt-settlement companies are another reason to be wary, the CFPB says. Debt-settlement companies will often instruct borrowers to stop paying their bills in a bid to force the creditors to accept a lower payment, or advise their clients to stop communicating with their creditors. The CFPB warns that this strategy can ultimately damage a person’s credit score and hurt their chances of getting credit in the future. The strategy also sometimes doesn’t work, and the borrower is left with additional penalties and late fees.
Finally, a borrower will likely be held responsible to pay the taxes on the extinguished debt amount. For example, if $5,000 in debt is lopped off the principal, the IRS considers this income, and it is subject to federal income tax. The borrower may not face the same penalty if they choose an alternative strategy to get out of debt.
An overwhelmed debtor doesn’t necessarily have to face a debt crisis alone. Nonprofit credit counseling is often available. A credit counselor offers a different type of service than a debt-settlement company.
Typically, credit counselors don’t promise to negotiate a reduction in the overall loan amount, but the goal is to lower monthly payments and the interest rate, enabling the borrower to attack their principal balance and get out of the hole. Often credit-counseling firms have arrangements with creditors that enable debtors to restructure their debt with lower interest rates and monthly payments. Debt-settlement companies, by contrast, usually have no such arrangements with creditors, the CFPB says.
Borrowers will often have to meet with a credit counselor for an initial consultation. Often these programs involve a debt-counseling component. Sometimes the borrower will have to pay a fee for the credit counselor to develop a payment plan. Once the plan is in place, the borrower often sends the credit counselor one monthly check, which covers their now-consolidated debt payment.
A borrower using a credit-counseling service usually has to agree to certain conditions and be willing to change their spending habits to avoid accumulating more debt, but can avoid many of the potential pitfalls involved in using a debt-settlement company. The bottom line, according to the CFPB, is that borrowers should exhaust all of their options before seeking the services of for-profit debt-settlement companies. One of the options to explore is seeking help from a nonprofit credit counselor.