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Debt Settlement Firm, Counselor, or Law Firm
Creditor’s incentives
The creditor’s primary incentive is to recover funds that
would otherwise be lost if the debtor filed for bankruptcy.
The other key incentive is that the creditor can often
recover more funds than through other collection methods.
Collection agencies and collection attorneys charge
commissions as high as 40% on recovered funds. Bad debt
purchasers buy portfolios of delinquent debts from creditors
who give up on internal collection efforts and these bad
debt purchasers pay between 1 and 12 cents on the dollar,
depending on the age of the debt, with the oldest debts the
cheapest. Collection calls and lawsuits often push debtors
into bankruptcy, in which case the creditor often recovers
no funds.
Common objections to settlement
There are four main objections to consumer debt settlement:
damages credit, increased collection calls, possibility of
lawsuits, tax consequences and the need to settle with all
creditors.
Settlement damages credit
The debt settlement damages the scores in credit report. A
credit report is used by creditors to judge past credit
performance to see if the applicant meet their criteria for
lending. Insurance companies uses a person's credit report
to determine premiums and prospective employers review the
credit report to establish the character of a job candidate.
Tax consequences
Another common objection to debt settlement is that debtors
whose debts are partially canceled outside the bankruptcy
system will need to report the canceled portion of the debt
as taxable income. (IRS Publication Form 982)
The IRS considers $600 or more of forgiven debt as taxable
income. The forgiving creditor must provide the taxpayer
with a 1099-C tax form. This form will list the amount of
forgiven debt and interest in Box 2. Taxpayers with portions
of personal loans forgiven may not subtract the interest
reported in Box 3 from the amount of reportable income on
this form.
However, the IRS does not require taxpayers to report
forgiven debt if the tax payer was insolvent at the time the
creditor forgave the debt. Being insolvent means that the
amount of a debtor’s debts are greater than his/her assets
(how much money and property the debtor owns). However, the
IRS adds that “you cannot exclude any amount of canceled
debt that is more than the amount by which you are
insolvent. For example, if a taxpayer is $10,000 in debt and
owns $3,000 in assets, he/she cannot exclude more than
$7,000 of forgiven debt from his/her income tax. Any
forgiven debt over $7,000 that year must be reported as
taxable income. |
History
As a concept, lenders have been practicing debt settlement
thousands of years. However, the business of debt settlement
became prominent in America during the late 1980s and early
1990s when bank deregulation, which loosened consumer
lending practices, followed by an economic recession placed
consumers in financial hardships. With charge-offs (debts
written-off by banks) increasing, banks established debt
settlement departments staffed with personnel who were
authorized to negotiate with defaulted cardholders to reduce
the outstanding balances in hopes to recover funds that
would otherwise be lost if the cardholder filed for Chapter
7 bankruptcy. Typical settlements ranged between 25% and 65%
of the outstanding balance.
Alongside the unprecedented spike in personal debt loads,
there has been another rather significant (even if
criminally under reported) change – the 2005 passage of
legislation that dramatically worsened the chances for
average Americans to claim Chapter 7 bankruptcy protection.
As things stand, should anyone filing for bankruptcy fail to
meet the Internal Revenue Service regulated ‘means test’,
they would instead be shelved into the Chapter 13 debt
restructuring plan. Essentially, Chapter 13 bankruptcies
simply tell borrowers that they must pay back some or all of
their debts to all unsecured lenders. Repayments under
Chapter 13 can range from 1% to 100% of the amounts owed to
unsecured creditors, based on the ability of the debtor to
pay. Repayment periods are 3 years (for those who earn below
the median income) or 5 years (for those above), under court
mandated budgets that follow IRS guidelines, and the
penalties for failure are more severe.
How it works:
Essentially, the debt settlement company negotiates on the
borrowers’ behalf with creditors to reduce the overall debts
in exchange for an agreement upon regular payments to be
made. Only credit card debts can be handled, not student
loans, auto financing or mortgages. For the debtor, this
makes obvious sense – they avoid the stigma and intrusive
court-mandated controls of bankruptcy while still lowering,
sometimes by more than 50%, their debt balances. Whereas,
for the creditor, they regain trust that the borrower
intends to pay back what he can of the loans and not file
bankruptcy (in which case, the creditor risks losing all
monies owed).
There are
obvious drawbacks – credit reports will show evidence of
debt settlements and the associated FICO scores will be
lowered as a result. There’s always the possibility of
lawsuit whenever debts lay unpaid. Since few creditors wish
to push borrowers toward bankruptcy – and the potential of
governmental protection against all debts. In addition, the
specific debts of the borrowers themselves affect the
success of negotiations. Tax liens or domestic judgments,
for reasons that should be clear, remain unaffected by
attempts at settlement. Student loans, even those not
federally subsidized, have been granted special powers by
recent legislation to attach bank accounts without
possibility of Chapter 7 bankruptcy protection. Also, some
individual creditors, including Discover Card, for example,
tend to have an aggressive resistance against negotiations.
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