Debt settlement is a method for handling your debt when it becomes too difficult for you to repay. Debt settlement is an alternative to credit counseling or bankruptcy, and like those options, debt settlement does not work for everyone and it has its drawbacks.
Why Creditors Settle Debts
Conceptually, debt settlement benefits both you and your creditor. If you default on your payments and show an inability to pay, your creditor must then expend time and money to make collection attempts before finally suing you and trying to collect on a judgment. The creditor will have to write off whatever amount it does not collect from the judgment. Debt settlement allows you to offer to repay only a percentage of the balance due in one lump sum in full satisfaction of your debt. The creditor may be willing to accept 60 percent of the balance due and forgive the remaining balance, because to do so would cost the creditor less in the long run.
How Debt Settlement Companies Work
You can settle your debts yourself by contacting your creditor directly. If you have a lump sum of cash and are behind on your payments, you can offer the money to the creditor in full satisfaction. If the amount is enough, the creditor will agree. However, companies exist that offer to take care of your debt settlement needs for you. These companies require you to send them a monthly payment for a set period of months. From this payment, the company takes its fees and puts the rest into an account to accumulate enough for your lump sum. Once enough money has accumulated in the account, the company negotiates with creditors on your behalf. Meanwhile, instead of paying your creditors, you have been paying the debt settlement company, and your accounts have become delinquent.
Account Delinquency
While you save your money to make a debt settlement offer, you are not paying your creditors. Your accounts become delinquent, and the creditors can send your account into collections. Debt settlement negotiations do not stop collection activity, and your creditors are permitted by law to continue collections and can still sue you for your delinquency before you settle the debt.
Income Tax Liability
Once your debt settlement is complete and the creditor has forgiven your debt, you will be taxed on the forgiven debt as if it were income. IRS and state taxing authorities consider debt forgiveness to be taxable income. For example, if you have a credit card with an outstanding balance of $12,000 and the credit card company settles with you for $7,000, the credit card company will forgive $5,000 in debt. Taxing authorities will treat that $5,000 debt forgiveness as if you had received $5,000 in income.
Out Of Pocket Costs
Debt settlement can be costly. Expenses related to debt settlement include the payments into the settlement fund, fees to the debt settlement company and income tax liability. In the example above, you have settled a $12,000 debt for $7,000. Your out-of-pocket expenses include $7,000 to satisfy the debt, the fees your debt settlement company charged, at least $700 in federal income taxes and any state income taxes you may owe.
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