An offer to settle a debt for less than you owe can be tempting, and may be your best option if you are seriously in debt with no means to repay it. But debt settlement has pitfalls as well, including additional taxes and significant damage to your credit score. In the long run, paying your debts in full, even if it takes longer, may save you a lot of money and trouble.
Credit Consequences
The fact that you settled a debt for less than you originally owed may end up on your credit report, and can remain there for some time -- up to seven years after you originally defaulted on the debt. Settling a debt for less than you owe can lower your credit score and make other lenders nervous about working with you. On the other hand, some people have managed to successfully negotiate the removal of a settled account from their credit report as part of the debt negotiation process. If you are offered the opportunity to settle a debt, get an agreement in writing from the creditor or collection agency that they will remove the account or report it as "paid in full."
Tax Consequences
Federal law treats canceled debt over $600 as taxable income for you and requires creditors to report the cancellation using tax form 1099-C. While you may be able to avoid paying taxes by claiming insolvency, you need to factor tax consequences when considering a debt settlement.
Long-Term Financial Consequences
While settling a debt offers short-term relief, it may cost you more money in the long run. Not only may you have to pay taxes on the forgiven debt, the damage to your credit score can cost you big time in higher interest rates over the next few years.
Debt Settlement Firms
Debt settlement firms specialize in settling your debts for you. Unfortunately, some of these companies do more harm than good. They may encourage you to not pay your bills while you save up enough money for a settlement, which can significantly damage your credit and possibly trigger lawsuits. They also often charge high fees. If settlement is your best option, you can probably do better negotiating on your own.
Alternatives
Credit counseling can help you with budgeting to get your bills paid off. Your credit counselor can set up a debt management plan to lower your interest rates and monthly payments while you pay your debts in full. Another alternative is bankruptcy. While bankruptcy is bad for credit, you don't have the tax consequences of debt settlement and may be your best option if you don't have the cash to settle your debts.
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