Advertisements advocating debt settlement programs make settling debts you cannot afford to pay seem like a safe and simple process. In reality, paying your creditor less than you owe to settle your debts is a risky undertaking and one you should only consider after familiarizing yourself with the potential consequences of debt settlement.
How It Works
A creditor settles a debt when it accepts less than the debtor owes as full payment, writing off any balance that remains. You can attempt to settle outstanding debts with creditors on your own or hire a third-party agency to negotiate a settlement agreement for you. Depending on your financial situation and the creditor's demands, you can pay a settlement either in one lump sum or in payments over time.
Considerations
While some creditors limit their financial losses by offering nonpaying debtors settlement agreements, no law requires them to do so. The Federal Trade Commission notes that a creditor reserves the right to refuse to negotiate your unpaid balance with you or any third party that you hire to negotiate in your stead. If you hire a debt settlement company or credit counseling agency to work with your creditors on your behalf, you still must pay the fees associated with the service, regardless of whether or not your creditor agrees to lower your debts.
Tax Consequences
If your creditor agrees to let you settle your outstanding balance, it writes off the unpaid remainder you owe as a tax loss. Federal tax laws require you to include the amount the creditor wrote off as income on your tax return. Your creditor will send you a Form 1099-MISC at the end of the tax year noting the exact amount it forgave. Depending on the amount your creditor forgave and the other information on your tax return, including the debt settlement balance as income could result in a tax liability.
Credit Damage
Few creditors will agree to lower your balance if you make timely payments. Only when payments cease and the creditor is in danger of losing money will it consider lowering your debt. Unfortunately, if the creditor makes regular reports to the credit reporting agencies, skipping payments in order to successfully settle the debt will result in missed payments on your credit file and eventual credit damage. Missed payments remain a part of your credit history for seven years.
Collection Lawsuits
Skipping payments to your creditor does more than lower your credit rating -- it causes your debt to increase even more. Each time you miss a payment, many creditors impose a late payment fee. This fee increases your debt and, by doing so, results in the debt accruing additional interest charges. Each month that you do not pay in the hopes of obtaining a settlement, your debt steadily grows.
Should the creditor refuse a settlement, your unpaid balance places you in danger of a collection lawsuit from your creditor. A lawsuit permits a creditor to collect the full amount you owe via force, such as through a wage garnishment order.
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