The strategy is to persuade people that it's in their best financial interest to stop making payments and instead send money to the debt-relief firm, which holds on to the funds with the intention of offering creditors a lump-sum offer for less than what's owed.
The tactic seems reasonable. Creditors don't want to have to write off debt completely or pursue people for years. If they can get something - anything from a borrower who isn't paying - they are more likely to negotiate to settle the debt.
But for many people, the salvation they seek from a debt-settlement company is likely to make matters worse, according to a report from the Center for Responsible Lending.
When people stop paying their debts as part of the debt-settlement plan of attack, their balances increase on average about 20 percent, the report found.
"Although debt settlement may first appear attractive, harms stemming from defaulting on debt may leave consumers worse off," the authors write. "These harms include damaged credit, aggressive collection attempts from creditors and continued growth of debt balances through default interest rates, late fees and other charges."
There are rules to help debtors who, against the advice of many consumer advocates, still seek the services of debt-relief companies. It is illegal for debt-relief services to charge up-front fees. Companies that sell their services over the telephone can't get paid until they successfully settle or reduce a customer's credit card or other unsecured debt. The firms are also prohibited from misrepresenting what they can do for debtors, in particular the percentage of debt that is typically erased.
The Federal Trade Commission recently charged an Irvine, Calif., company for making promises it didn't keep related to debt relief. The FTC said the company claimed it could get people out of debt in 18 months and reduce the amount they owed by 30 to 70 percent. People were told to stop paying and to stop all communications with their creditors.
Some consumers were billed as much as $10,000 and yet left worse off, with some losing their homes, having their wages garnished and filing for bankruptcy protection, according to the FTC complaint.
The Center for Responsible Lending points out the following things to consider if you decide to spend thousands of dollars for debt relief:
* When you stop making payments to your creditors as part of a debt-settlement plan, you are likely to trigger penalties, higher interest rates and other fees, which will cause your balance to grow even more while you wait to see if debts can be settled for less than you owe.
* The quick fix isn't as fast as you might think. You could be in a debt-relief program for three to four years.
* There's no guarantee your creditors will give you a deal. Many creditors refuse to negotiate with debt-settlement firms and may instead decide to pursue legal action against you.
* Weigh the fees you pay with the growth in your debt because it impacts any savings you may realize.
* Keep in mind that you may have to pay taxes on any debt forgiven because the IRS views the savings as taxable income.
The FTC also provides really helpful information on debt settlement. For tips on other ways to pay off your debt and how to avoid debt-relief scams, go to ftc.gov and search for "Settling Credit Card Debt."
Obviously, I'm not a fan of debt-settlement plans. Seems to me the money you pay the companies could be used to pay your creditors. No matter how you got into debt, you have to be prepared to put in some hard and uncomfortable work to get out.