Debt settlement is a method for eliminating excessive debt, and it may be preferable to bankruptcy for many. Debt settlement resolves unsecured debt such as credit cards through negotiated agreements in which the borrower pays less than the full amount owed and the creditor accepts it as full payment. However, only past-due accounts are eligible, meaning people trying to negotiate a debt settlement must stop making payments to allow their accounts to fall behind.
Credit Impact
Debt settlement hurts credit scores, although less than bankruptcy. Settlement information is considered very negative, and it remains on credit reports for seven years. Bankruptcy remains on credit reports for 10 years, and it is the worst possible information for your credit report. Settlement offers may be available on credit cards and other accounts after payments are behind by about three months, and better settlement offers may be available at around six months as creditors prepare to list the account as charged off and send it to a collections agency.
Missed Payments
Missing payments on one account to facilitate a settlement agreement could affect other accounts as well. Creditors regularly review credit reports for updates about their customer's finances. A credit card company noticing that you are missing payments on another card could reduce your credit line or close the account because it fears you are having financial problems. In addition, not making payments on any account hurts your credit score even before the settlement is added to your credit report. People who are considering not paying their debts to settle accounts should prepare to live without credit for a while.
Bill Collectors
Bill collectors and collection agencies are another issue for debt settlement. Collection activity will increase each month accounts are past due, eventually resulting in numerous phone calls and letters, some on a daily basis. The Fair Credit Reporting Act, a federal law, offers some protection against the harassment, including provisions for not allowing collection agencies to contact you by telephone.
Risks
There is no guarantee debt settlement will work. Creditors are not required to offer settlements, and they can file a lawsuit for the full amount instead. However, most creditors and debt collectors would rather settle than go to court. SmartMoney reports that settlement payments typically range from 20 to 70 percent of the amount owed, with most cases settled for around half the balance.
Tax Issues
Savings achieved through debt settlement are often treated as income by the Internal Revenue Service. For example, assume you settle a $10,000 credit card debt for $5,000. That's a significant savings, but the IRS may require you to boost your reported income for the year by $5,000, because the savings are considered income for tax purposes. Some people may qualify for an exception to the requirement if they can show they are financially insolvent because their debts are greater than their assets.
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