David Bach The Automatic Millionaire

In the reader comments for my last column, some of you raised the issue of debt settlement. This differs from credit counseling and debt management plans (DMPs) in that debtors pay creditors a negotiated percentage, rather than the full amount, of their debts.

A Rock and a Hard Place

DMPs can get you lower interest rates and flexible payment schedules while you work out your debt problem. They'll also help you manage your finances to avoid trouble again. If you can find a way to pay your debts in full using a DMP, that's probably best for your credit profile.

But what if you simply can't? What if you have large medical bills, illness, unemployment, divorce, or other big and unforeseen financial problems?

You may find yourself caught between the rock of bankruptcy and the hard place of an unmanageable debt load -- with no real way out. You may have stopped making payments on all or part of your outstanding debts, or you may have reached the point where your debt has been sold off to a new creditor.

Dwindling Options

For many years, bankruptcy was the primary vehicle for those otherwise unable to cope with an impossible debt load. But now that's become harder, too, with new laws that took effect in late 2005.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was designed to limit "abusive" consumer bankruptcy filings. Among other provisions, it forces a more stringent means test to qualify for a Chapter 7 liquidation-of-debts bankruptcy.

The new law effectively lowers income thresholds and assigns higher values to personal assets you own. If your income exceeds state median income and you can pay as little as $100 a month after housing, car payments, past-due taxes, and child support, you may not qualify for Chapter 7. Those not qualifying for Chapter 7 can file Chapter 13, but Chapter 13 requires eventual repayment of all secured debts and as much unsecured debt as possible.

Settling for Less

The means test and other provisions of the law require more paperwork and attorney involvement, effectively raising the cost of the bankruptcy process for either "chapter." You must show that you've already been through credit counseling, and there are new limits for the number of times someone can file for bankruptcy in a given period.

In a nutshell, bankruptcy is still possible, but much more difficult and expensive for those in dire straits. That plus the fact that the designation "BK" leaves the biggest hit on your credit record make it clearly not a good place to go.

So what can you do if bankruptcy isn't an option, or not the route you've chosen to take? There's another way: Under the right circumstances, you may be able to negotiate a debt settlement for your unsecured debts like credit card or hospital bills. A debt settlement allows you to discharge debts for some percentage of the full amount.

How Debt Settlement Works

Like DMPs, debt settlement is typically handled through a company specializing in managing the settlement and dealing directly with the creditors. As with credit counseling, there are legitimate players -- and more than a few swindlers.

First, the debt settlement company will screen you to decide if you're a good candidate. According to David Leuthold, vice president of the Association of Settlement Companies (TASC), about 40 to 60 percent of those who approach a settlement company are considered eligible based on their debts and personal financial situation. "Eligible" usually means you have too much debt for any foreseeable income to handle, are unable to make minimum payments, and have indeed stopped making payments on the debt.

If you qualify, you'll enter into a contract with the debt settlement company. The contract will spell out the actual costs of the program (discussed below) and will include a series of standard disclosures. As always, when you sign anything, be sure to read it in its entirety. And if there's anything you don't understand, be sure to ask questions.

The company then negotiates a plan with each of your creditors to pay a percentage of the outstanding debt. That percentage varies by case. Most settlements are 50 to 80 cents on the dollar, but creditors may occasionally go lower. Your accounts with these creditors are effectively closed; you may be allowed to keep or obtain one credit card for emergencies or other purchases, like renting a car, that require a card. When the settlement company gets an agreement with a creditor, they (and you) get a settlement letter describing the terms of the settlement.

The Payment Process

Next, the debt settlement company works out a payment schedule that you'll adhere to, typically over a two- to three-year period based on the settlement sum. It's important to note that a reputable debt settlement company will never take your payment directly -- that wouldn't comply with TASC standards.

Instead, money can be saved in your own bank account, or more typically with a third party payment processor or "money transmitter" firm, usually one of two firms specializing in this activity. The account, like an escrow account, is set up in your name, usually with regular automatic drafts from your checking account to fund it.

The debt settlement company gets information from the payment processor, and should give you online access to your debt settlement account with monthly statements. When sufficient funds are accumulated, creditors are then paid, and letters are exchanged confirming discharge from your debts. (Be sure to keep a file of all of your records.)

A Rating Hit

Your credit record will then be updated. In some cases, the company may be able to negotiate a more favorable wording for your credit record, like "paid" or "settled." According to Leuthold, however, companies "usually can't dictate what creditors will report."

A settlement certainly won't help your credit rating, but it isn't as bad as bankruptcy. Your rating will suffer during the settlement period because payments don't go to the creditor until the lump-sum settlement has been accumulated. Once the settlement is handled and documented correctly, the creditors can't approach you for more.

Take Precautions

There are many advantages of debt settlement. First, it can help you avoid bankruptcy, which will allow you to rebuild your credit sooner. It also reduces your liability and provides peace of mind by doing away with further harassment by creditors.

For many, it's the only solution. But be aware of the following when considering debt settlement:

• Cost: Debt settlement is a service, and you pay for it.

There are two fee models: a flat, upfront 15 percent of the outstanding balance, or 25 percent of the reduced amount. Some experts recommend the latter because it rewards a better and faster settlement. You also need to understand how creditor fees and interest will accumulate during the settlement period.

• Tax liability: The IRS generally considers discharged debt to be income. You'll get a 1099 for the discharge amount, and will owe taxes on it.

• No guarantees: It's all up to the creditors, and "no deal" is a possible outcome.

Also note that debt settlements don't work for secured debts -- mortgages, car loans, etc. -- where repossession, not settlement, is the remedy. (That said, in his March 4, 2008, speech, Fed chairman Ben Bernanke called on bankers to take a new look at settlement for mortgages.)

Finding Reputable Debt Settlement Firms

If you're already working with a satisfactory credit counseling agency, they may be able to handle a debt settlement for you, or refer you to a settlement company. If you know someone with a positive debt settlement experience, a personal recommendation is always good to follow.

If not, log on to TASC's website. In existence now for two and a half years, this trade organization has the dual mission of standardizing debt settlement procedures among its 115 member companies and working a legislative agenda with government authorities. "Our companies have a strict code of ethics and disclosure," says Leuthold.

If you go down the debt settlement path, I strongly recommend working with a TASC member company. And my usual advice applies here as well: Always check out a company with the Better Business Bureau before you hire them.