Bad Debt Sales: Buying Debt Explained in Simple Terms

If you’ve ever heard the term “buying debt” and wondered what it means, here’s a straightforward explanation.

What Is Buying Bad Debt?

Buying debt is the process where a company (or sometimes an investor) purchases unpaid accounts receivable from creditors, such as banks, credit card companies, or service providers. These unpaid accounts, often referred to as bad debts, represent money owed by individuals or businesses that hasn’t been collected.

Why Do Creditors Sell Debt?

Creditors sell debt to recover some of the money they’re owed without dedicating more time and resources to collection efforts.

Selling debt allows creditors to write off bad debt and reduce bad debt expenses on their financial statements. By selling unpaid accounts to debt buyers, creditors can:

• Receive Immediate Cash: They get upfront payment, even if it’s only a fraction of the debt’s face value.
• Reduce Costs: Selling debt eliminates the need for internal collection efforts.
• Focus on Their Core Business: It allows creditors to move on from delinquent accounts and prioritize serving current customers.

How Does Buying Accounts Receivable Work?

• Debt Portfolios: Creditors bundle unpaid accounts into portfolios. These portfolios often include credit sales that have been deemed uncollectible. These portfolios may include hundreds or thousands of accounts and are categorized by debt type (e.g., credit card, medical, or personal loans) and collectability.
• Sale Price: Debt buyers purchase these portfolios for a fraction of their face value. For example, a $1,000 debt might sell for $50 or less, depending on factors like its age and likelihood of collection. The direct write-off method is sometimes used to account for these uncollectible debts.
• Collection Efforts: After purchase, debt buyers either collect directly from the debtors, hire third-party collection agencies, or resell the debt to other buyers.

Is Buying Debt Legal?

Yes, buying debt is legal, but it’s a heavily regulated industry. In the U.S., laws like the Fair Debt Collection Practices Act (FDCPA) ensure that debt collection is conducted ethically and fairly. These regulations protect consumers from harassment, misinformation, and unfair practices, while also setting clear guidelines for debt buyers.

Why Do Companies Buy Business to Business Debt?

Debt buying can be profitable when managed effectively. Companies may also buy debt to manage business bad debt and potentially benefit from business loan guarantees. Here’s why:

• Potential for High Returns: Debt buyers aim to collect more than they paid for the accounts.
• Specialized Expertise: Many debt buyers are skilled in collections and use advanced tools to maximize recoveries.
• Opportunities for Discounts: Older or harder-to-collect debts are often sold at significant discounts, offering higher potential margins.

Risks of Buying Bad Debt Expense

While buying debt can be lucrative, it also involves risks:

• Low Collectability: Many accounts are difficult to recover, resulting in potential losses. Maintaining a bad debt reserve can help mitigate the risk of low collectability.
• Regulatory Compliance: Violating collection laws can lead to lawsuits, fines, and reputational damage. Accurately estimating doubtful accounts is crucial for regulatory compliance.
• Operational Costs: Debt buyers must invest in infrastructure, staff, and technology to collect efficiently.

The Bottom Line

Buying debt is a unique financial strategy that benefits both creditors and debt buyers when handled responsibly. Creditors recover part of their losses, while debt buyers gain an opportunity to profit through skilled collection efforts. However, it’s not without challenges, requiring careful compliance with regulations and a clear understanding of the risks involved.

Got questions about debt buying? Feel free to ask—this industry is as fascinating as it is complex!