What are debt relief companies? 3 things you should know before using one

Debt relief companies, sometimes called debt settlement companies, are one option for those struggling with credit card debt, tax debt, personal loan debt, and other types of unsecured debt. 

These companies can help you manage certain types of debt, but they won't be the right solution for everyone. Debt relief companies can't help with secured loans, which usually include mortgages and auto loans. And while you might think nothing's more damaging to your finances than out-of-control debt, rushing into an agreement with a debt relief company can create a whole new set of problems.

Here's what you need to know about this service and whether it's right for you.

Debt relief companies, programs and services can help you reduce the amount of debt you owe by negotiating with creditors on your behalf.

During the debt relief process, the company will typically advise you to stop making payments to your creditors and instead put that money in a savings account set up by the debt relief company. While you're saving, the debt relief company negotiates with creditors to lower the amount you'll have to pay (the logic being that creditors will rather get some of your money now rather than wait for you to settle the full amount). The debt relief company then uses the funds in the savings account to pay the negotiated amount.

CNBC Select researched more than a dozen debt relief companies, and New Era Debt Solutions was the best overall, thanks to its (slightly) lower fees and high customer satisfaction ratings. If you have a large amount of debt (think more than $10,000), then National Debt Relief is also a strong choice.

However, it’s worth noting the risks of using these services. The Consumer Financial Protection Bureau (CFPB) states that in many cases, companies are unable to settle all debts. It adds that users may be charged fees for the management of the savings account and that stopping debt payments could result in creditors’ collections departments putting more pressure on debtors and even debt-collection lawsuits. And, while you're not paying, creditors can continue to charge late fees and interest.

These services also aren’t free: based on CNBC Select’s research, most for-profit debt relief companies charge between 14% and 25% of the total debts enrolled in the program. Oftentimes, these companies require you to have at least $10,000 worth of eligible debt to enroll, which would bring the minimum fee to somewhere between $1,400 and $2,500. These fees should be charged after your debt is settled — the CFPB cautions against doing business with a company that charges fees before settlement. 

The debt settlement industry is rife with bad actors and scammers, but even when you use a legitimate company you face some financial tradeoffs. Here's what you need to consider before enrolling in a program.

Your credit score is vitally important: It not only determines your ability to get a credit card, it can also affect your eligibility to rent or buy a home or get an auto loan. Debt settlement can lower your credit score in a few ways.

Since these companies encourage people to stop making debt payments, credit scores typically decrease. In the FICO scoring system, payment history makes up 35% of a credit score and can remain on your report (and affect your credit score) for up to seven years. 

The debt settlement itself will also cause a credit score hit. Even if the account is settled, it will appear on your credit report that you had to use a settlement company, which is considered a negative in the eyes of potential lenders. While settling debt is better than not paying at all, you can expect to see a hit between 100 and 125 points according to Debt.org. That’s still less of a decline than what you would see with bankruptcy, but it's still a significant amount. 

If your debt settlement experience is successful, you still have one more place to pay: the U.S. Government. Under US tax law, almost any debt over $600 that’s forgiven is considered taxable income, and you'll receive a Form 1099-C, Cancellation of Debt from the lender to report on your annual income taxes. 

For example, if you have $20,000 worth of credit card debt and pay $10,000 to settle that debt, the remaining $10,000 will be added to your income for the year. That could increase your tax obligation for the year.

You should consult a tax professional who can help figure out how debt settlement will affect your taxes before moving ahead with a settlement company.

While there are some legitimate debt relief companies, debt relief scams do exist. Some common red flags include: 

• Unsolicited contact. Reputable debt settlement companies shouldn’t cold-call potential clients. 
• Upfront fees. A debt relief company should never ask for payment up front, and doing so could be a violation of FTC rule. All of the companies CNBC Select reviewed require payment upon settlement. 
• Unrealistic promises. Avoid companies that make guarantees that debts will go away or be paid for very little. 
• Telling you to stop communicating with creditors. If a debt relief company asks you to cut all ties with the creditor, the CFPB recommends not doing business with them.

Make sure to evaluate any debt relief company you consider carefully and contact your state’s banking regulator to find out if a particular company is licensed to do business in your state, if required. 

If you’re concerned about using a debt relief or settlement company, there are several ways to avoid it altogether. Here are some ways to navigate the process. 

Everything that a debt relief company does for you can be done on your own. While it won't be easy to carve out the time to negotiate with creditors and follow your own savings plan, it’s far from impossible. 

The CFPB recommends several steps for those wanting to take a do-it-yourself approach. Start by listing the debts owed, which company holds the debt and each account’s balance. The CFPB has several sample letters that can be sent to creditors to get this information. It also suggests creating a budget and determining how much you can reasonably put towards debt each month, and ultimately how much is available to be paid to each creditor as a settlement, either in a lump sum or in payments. 

To negotiate your own debt settlement, you’ll want to contact the debt collection company (which is not necessarily the original creditor). Then, make sure to create records of your conversations and get an agreement in writing before making a payment.

While this can be a time-consuming process, it avoids the hefty fees charged by debt relief companies. 

Even when settling the debt yourself, you'll almost always have a tax bill for forgiven debt and a lowered credit score from not being able to pay the debt in full (rather than the negotiated amount).

If you think you have the resources and ability to pay the debt back completely, you have several options: 

• Consolidate the debt. If you’re overwhelmed by the number of debts you have, a debt consolidation loan could help you bring all of your debt into one monthly payment with one fixed interest rate. From there, you can start making a budget for paying off the debt. And you don't need great (or even decent) credit to get one of these loans. CNBC Select’s top picks for debt consolidation loans for those with bad credit include Upstart, a lender that works for even those with no credit history, and considers factors beyond your credit report like employment history and education history. Avant, another lender, is an excellent choice if you want low origination and upfront fees, as well as a quick turnaround for approval and funding. 

• Negotiate the payment schedule. You can negotiate an agreement with your creditor to lower your interest rate or minimum monthly payment. 
• Consider debt repayment tactics. Some have found success following a debt repayment method, especially when combined with negotiation and consolidation, such as the debt avalanche or snowball methods. The avalanche method focuses on making minimum payments on all debts and putting any extra cash toward debts charging the highest amount of interest. The debt snowball method builds momentum by prioritizing paying off the loan with the smallest balance first, so that you can feel the satisfaction of eliminating a debt completely sooner rather than later.

If you need help with tackling your debt, for-profit companies aren’t the only option. Non-profit credit counselors are available in most of the country. While they’re not free — many charge fees for their services — a credit counselor could be a cheaper alternative than a debt relief company. 

Credit counselors can help you create a debt management plan that works differently than debt settlement would. Instead of asking you to stop payments, a debt management plan advises you to make one monthly payment to the counselor who then splits it among your creditors. Credit counselors can work to lower your monthly payments by extending the periods you can repay and lowering the interest rates and fees of your debts. 

To find a credit counselor, you can try two professional organizations, the Financial Counseling Association of America or the National Foundation for Credit Counseling. 

Debt relief companies work to settle your debts, reducing the total amount you owe. But in addition to a large fee, their services can come with risks, including credit damage, a large tax bill, and even potential lawsuits. For these reasons, consolidating debt to pay off on your own or creating a debt management plan with a credit counselor could be strong alternatives to consider.

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