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Debt Settlement
Also known as Debt Arbitration or Debt Negotiation, is an aggressive approach to debt reduction. |
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Brief history of debt settlement |
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. The settlements ranged between 25% and 65% of the outstanding balance. |
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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 only pay between 1 and 7 cents on the dollar. Collection calls and lawsuits often push debtors into bankruptcy, in which case the creditor often recovers no funds. |
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Common objections to debt settlement |
There are five main objections to consumer debt settlement: damages credit, increased collection calls, possibility of lawsuits, tax consequences and the need to settle with all creditors.
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 Form 980)
The Internal Revenue Service 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. |
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Debt Settlement Trade Associations |
Due to the rise of debt settlement as a debt relief alternative to bankruptcy, groups working in the industry have established trade associations to help secure industry standards that will protect consumers against unethical business practices. These trade associations were also established to lobby state governments because many state legislatures are passing laws that restrict out-of-state companies from providing debt negotiation services to in-state residents. The two major trade associations are the United States Organization for Bankruptcy Alternatives (USOBA) and The Association of Settlement Companies (TASC). Both of these organizations publish on their websites information about debt settlement and the debt settlement industry.
Individual Debt Settlement consultants can obtain thorough industry training and Certification through The International Association of Professional Debt Arbitrators. (IAPDA). |
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Our Featured Question & Answer of the Day For Friday
Q. Why Would a Creditor Agree To Accept Less?
A: The primary reason a creditor will accept a settlement is because it is cost effective for the creditor, plain and simple. The degree of the discount (how much they will forgive) will vary case-by-case; therefore, a creditor will take into account many factors when determining their bottom line on accepting a settlement.
The primary factor creditors take into account is what percentage of the debt is likely to be collected in the future if they do not accept an offer now. The other factor creditors look at is what is the likelihood of collecting the full debt through normal collection activity or through the legal system.
Before they agree to any settlement, they will often take into account, debtor's income, the state they live in, the age of the debt, type of debt, debtor's assets, etc.
Professional negotiators will put a case together that will make the creditors understand that it is in their best interest to settle the debt and accept their offer. |
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