Risks of Debt Settlement

When you are overwhelmed by debt, debt settlement can seem like the only way out. Debt settlement means negotiating with your lenders and getting a reduction in the amount that you owe and in return making a one-time payment for that amount. However, attempting debt settlement comes with risks to your credit score and may leave you in a worse financial position.

Credit Score

Lenders are motivated to settle your debt only if they believe you will be filing for bankruptcy. If you go into bankruptcy, lenders who have given you unsecured loans will likely get nothing. Therefore, they would prefer to negotiate and get at least a partial return on the debt. However, before a lender will negotiate, he must be convinced that you are going to be filing for bankruptcy and this means that you have to stop making payments on time. Ceasing payments builds up your savings to make the one-time payment when the debt is settled but will also bring down your credit score. Additionally, your lender may report the debt as "settled for less than owed" which is a negative for your credit report and score.

Income Tax

According to the Internal Revenue Service (IRS), if your lender forgives part of your loan, this money counts as income for tax purposes. Your lender will send you a 1099-C form listing the amount of the loan that was forgiven. You must report this information on your taxes as part of your income.

Escalating Collection Activities

There is a risk that your lender will increase collection activities to attempt to get the money you owe before you file for bankruptcy in response to you starting the debt settlement procedure. This can include sending the account to a collection agency or calls. Your lender may even go so far as to file a lawsuit against you to collect the debt.

Fees and Expenses

Many companies exist that offer help in the debt settlement procedure. Such assistance can be good, as the companies will have more experience negotiating with lenders and an understanding of how much they can expect to get your debt reduced by. However, these companies charge fees that can be quite large. Be sure to know how much you will be charged before you use such a company. Other fees you may face come in the form of late charges for missing payments that can add to your total debt.