This pandemic has thrown a lot of people in a deep financial grave. With so many people losing jobs and being unable to pay their debts has been an added burden to financial problems. Having said that Debt Settlement seems like a reasonable thing to do. Why not, one can always start fresh and work from there.
Is it really worth it?
I want to dwell a little deeper in understanding this as an option so that we can know what we are talking about.
What Is Debt Settlement Anyway?
It is when you choose to pay anything less than what you actually owe to your bank or lender. For example, let’s you have a credit card with a total outstanding balance of ₹50000.00 and due to financial hardship, you are in default of making regular payments.
However, you choose to speak to the bank or the lender and come to a mutual agreement that you would pay them, 50% of the actual amount, i.e ₹25000.00. In this case, you would save 50% of the money owed to that bank.
In simple terms, this is how debt settlement works. Banks or other creditors have been offering this as a parting solution to consumers that are unable to pay back the full amount of debt. The settlement percentage I quoted is just an example. There’s no set benchmark of what percent of settlement that a bank would typically offer.
It sounds like a perfect way to end the contract with the creditor, the bank loses 50% of the money and you save the rest of the money. Saves you from the emotional stress that you go through every day of receiving a million phone calls asking you to pay the debt.
Although, it sounds lucrative, saving 50% and getting away with paying the full balance. Remember that everything has a price. In this case, your Credit Score and an extended period of rejection of loans and credit by these banks.
Why Is Debt Settlement Bad For You?
About 20 years, there was no concept of Credit Ratings or Credit Scores in India. In fact, there wasn’t much liquidity in Credit Cards and Personal Loans as well. Not many people depended on credit in order to deal with their day-to-day expenses. People believed in the concept of savings or making safe investments either in real estate, gold, or fixed deposits.
A lot of things when the whole generation changed especially 2001 onwards. New multi-national companies were entering bringing exposure from the west. That gave a surge in the use of the credit that banks usually offered. The exposure alone doesn’t change anything. Whereas, insufficient knowledge of managing Debt – Income ratio was a big blind spot.
That resulted in an inability to pay what people borrowed. Not realizing the effects of a good credit score, most people didn’t mind leaving unresolved credit card bills or loans. Of course, the collection industry was without a leash and the harassment was beyond imagination.
I mean, if you really can’t afford to pay the best shot was to find ways to evade the debt completely. A few years down the line, when people realized the value of a good credit score, it was too late already. Even if one was now willing to pay back what they owed.
Let’s take a look at how the Debt Settlement Companies function to better understand the correlation of everything that we have read so far. In addition, I am going to cover how it continues to affect you.
1. Intentional Default
If you ever tried to negotiate a resolution with a bank or a private money lender, they’d typically offer to freeze the interest, block your credit card and allow you to pay back the full amount due in installments.
It is a sound strategy to collect the complete balance and at the same time, it doesn’t hit your credit score. In addition, it also restricts you from using the credit card going forward.
However, if you approached them looking for a settlement the bank would deny it. Let’s look at it this, why would any institution accept anything less than what you genuinely owe to them. Whereas, if you don’t pay anything to the bank for several months, they realize that accepting something is better than not getting anything at all. Of course, by this time your credit is severely affected.
Debt Settlement Companies (DSC) use the same tactic, whether you are in genuine financial hardship or not they will recommend you to stop paying the banks. A DSC will not be able to settle an account unless the outstanding bill has been unpaid for a longer duration. In fact, the older it gets the easier it is to settle the debt. This is especially true if they are looking to settle it at an extremely lower settlement percentage.
2. Creating History (Bad)
By defaulting on your loans and bills, you are severely impacting your credit score. That’s something that you are mentally prepared to do at this time. However, what you probably don’t realize is how long it is going to take for you to recover the credit ratings back again.
There are various factors that affect the credit score in general but it could take nearly 5-7 years before your credit ratings start to improve again. For eg., let’s say that you have 5 different credit cards that you managed to default on and eventually settled with them. These 5 banks in most cases are India’s largest banks. They all have a record of you defaulting with them. Considering that you defaulted with them, even if you manage to improve your credit score, these banks would never ever give you a credit card or an unsecured loan ever again.
It’s simple right. Generally, you would never go back to your ex if they cheated on you. I mean, in most cases at least. The banks see you as an ex that cheated. They’d never have that kind of trust with you again. I am sharing this from my own experience.
I defaulted on a credit card and eventually settled with the bank. However, a few months later I opened a savings bank account with the same bank. I used that same bank account for all my deposits, 12 years down the line, they would still not give me a credit card.
3. Tricky Payment Options
Let’s say that you owe ₹500000.00 in credit cards and personal loans. The Debt Settlement Companies would typically offer to settle your debts with a 50% discount. Sounds incredible right?
They then charge you 15%-20% of the total debt value as their fee. That means that you pay 50% to the bank and 20% to the DSC. Now that results in you actually getting a 30% discount only. Plus, there could be many other miscellaneous fees.
Now you won’t have actually had the 70% of the total debt to be paid towards the settlement and the fee. What they do is, break that 70% into a payment plan that you can afford. 12, 24, 36, or 48 months is the usual number of months. They take the money from you and keep it in a special purpose account which is also known as an escrow account.
It sounds easy and doable, in case you end up taking a payment plan that will stretch the entire program for let’s say 4 years, that automatically implies that these credit card bills are going to show in default for years.
In simple words, recovery on the credit score after 4 years of default is going to be a hard nut to crack.
4. Active Interest Rate
One of the key things to remember is that these credit cards and loans come with an interest. It is typically 36% on Credit cards and about 15% on personal loans. What that means, is that when you stop making payments towards these debts the banks continue to charge the interest rate.
From the earlier example, we know that including the fees and settlement percentage, you are almost paying 70% of the outstanding debt. With an active interest rate, you are going to be actually paying something close to what you originally owed to the banks.
Keeping this factor in mind, it’s not really worth going through a settlement process and having your credit score impact for the coming years.
You’d rather benefit from making arrangements with the lenders directly into paying off the balances as soon as your financial situation changes. Even though in default, paying off everything towards your outstanding balance can show a significant difference in your credit report.
5. Contract Trap
Most of such companies tend to design a contract that protects them more than it protects you. You would tend to notice that they would not specify a performance guarantee. You wouldn’t typically read a 20-30 page contract for sure.
Whatever promises they make are usually based on the past settlement processes and everything is based on historical data. The data sometimes is presented to the customer based on what selling techniques they are using.
In addition, if they fail to meet the average settlement rate of 50%, they’d typically have you pay more towards the program to cover the shortage of funds. Resulting in you adding more funds towards the program or end up extending the program by few more months.
6. The Unknown
The whole debt settlement industry experience is fairly new in India. That means that we are discounting the possibilities of changes in the law in upcoming months, or the lenders using a different strategy. Banks or creditors might be settling accounts at a really low settlement rate, but when they notice a trend of such companies coming up with large volumes, they’d adopt to changes in the policies and increase the settlement rates.
This is exactly what happened in the United States of America. Debt settlement companies took everything for granted, clients were duped in false promises that they may or may not be able to fulfill. The laws came up very strong that made doing a debt settlement business in the USA really difficult. Creditors adopted new policies and leveled the playing field.
Just because things are going in a certain direction doesn’t mean that they will continue to do so. To put things in perspective, debt settlement is strictly banned in nearly 35% of the states in America.
Being in debt is awful, it can affect our mental peace, ability to make sound decisions and it is a very stressful phase of our lives.
That only means that we should take a moment to carefully analyze the best suitable options in front. In case you still decide to go through with the Debt Settlement Company, make an effort to understand what’s exactly possible and you know the potential consequences and risks that are involved.
If you focus on finding a resolution, there are always options to consider and in most cases, you would end up finding solutions that are best for your needs.