If collection agencies are hounding you over old debts, an offer to settle your debt for less than you owe may sound appealing. Although settling a debt for less than the full amount may not have a detrimental effect on your credit, it won't improve your credit score, and it can also hurt you financially.
Settlement
When a debt collector offers to settle your debt for less than you owe, he's not doing you a favor. Instead, he's working on the principle that something is better than nothing. He has bought your debt for pennies on the dollar, so the chance that he's going to break even or turn a small profit is good. If he reports your payment to the credit bureaus, it's not really a point in your favor, because he's reporting that you only paid a fraction of the original debt.
Credit Effects
By the time you settle a debt in collections, most of the damage to your credit report is already done. The harm began with the first payment you missed, and compounded when your original creditor wrote off the debt as unserviceable, or turned it over to a collection agency. By neglecting to pay your creditor, and allowing your debt to go into collections, you've indicated that creditors can't trust you to pay your bills. If the collection agency reports the debt payment as a settlement for less than the full amount, your score may even go down. Furthermore, having settled debts on your credit report is often a red flag to prospective lenders.
Written Agreements
If you wish to accept a settlement offer, Bankrate's Steve Bucci recommends that you contact the collection agency in writing, and ask them to send you a written agreement that sets forth the terms and conditions of the deal. This agreement should specifically stipulate that your payment will constitute "payment in full." If the agreement is acceptable, send the collection agency a cashier's check or money order in the agreed-upon amount, along with a copy of the agreement. To ensure that the collection agency receives your payment, use certified mail and request a return receipt. Keep copies of all these documents in your files, so that you can prove you paid the debt. Not doing so can leave you open to harassment from yet another collection agency.
Tax Implications
When you agree to a debt settlement that entails forgiveness of more than $600 in debt, the collection agency will report this amount to the Internal Revenue Service, which views it as taxable income. If this happens, you may have to pay tax on this amount when you file your next tax return.
Statute of Limitations
Depending on where you live, debt collectors may be trying to settle on a debt that's past the statute of limitations, which means it's no longer a viable debt. Each state has its own schedule for statutes of limitations (see Resources). Check your state's limitations on debt collection before agreeing to settle an outstanding debt with a collection agency.
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