Negative Effects of Settling Debt

If circumstances have made it impossible for you to keep up with your debt obligations, there are a number of options you can weigh. You might simply walk away from the situation and accept whatever fallout may come. You can file for bankruptcy. You can take a second or third job, applying every bit of your pay to your debts. Another option is to negotiate with your creditors to settle your debts for less than you owe. While debt settlement can provide you some financial relief, there are several negative effects you may experience.

Credit

Debt settlement will likely do considerable damage to your credit report. Just how much damage you experience will be based, in part, upon how strong your credit was prior to the crisis. If your credit was battered prior to settlement, you may simply see a dip in score. If prior to your time of financial hardship you were able to pay all of your obligations on time and enjoyed a reasonably high credit score, you'll see a more dramatic plunge. It can take years of effort to pull your credit back up to a healthy level.

Taxes

You may be responsible for paying taxes on the debt that has been forgiven by your creditor. For example, if you owed $6,000 on a credit card but settled it by paying $2,500, your creditor would report the $3,500 you didn't pay as a write-off to the IRS. The creditor would then send you a Form 1099-C which the IRS expects you to include as income for the year. There are exceptions to this rule, so check with a tax professional before making any decisions.

Scams

Negotiating with debt collectors can be a challenge, but dealing with debt settlement companies can be even worse. In 2011, The New York City Consumer Affairs office cracked down on 15 debt settlement companies that the department considered to be predatory. The companies in question allegedly manipulated people into making payments to them each month rather than to the people's creditors. The companies allegedly promised to negotiate on the clients' behalf but failed to do so, or allegedly collected such exorbitant fees from the clients' monthly payments that there was little left for negotiating or paying down debts.

Emotional Toll

You must be prepared to experience a level of emotional stress as you deal with creditors. Your phone may ring incessantly, and you will sometimes speak with rude collection agents. The terms of your debt settlement agreement may not seem clear, or you may worry that you're doing something incorrectly. You're responsible for keeping records of the contact between you and the creditor and determining how much you will be able to pay. Only you can decide whether the weight of your debt makes going through the settlement process worth the trouble.