For many creditors, something is better than nothing. If a creditor thinks you are going to default on a bill or file for bankruptcy, it might settle your account for a percentage of what you owe. But there's a downside to debt settlement: You may owe taxes on your forgiven debt, and your credit report may reflect the settlement to the detriment of your credit score.
Debt Settlement
In debt settlement, you negotiate with your creditors to pay a portion of your debt in exchange for the cancellation of the balance. Some creditors will expect you to pay the full amount of the settlement at once, while other creditors may let you pay the reduced balance in installments. When negotiating a debt settlement, it is usually a good idea to offer a little less than you can afford, which allows you some room for bargaining. In many cases, you can negotiate a settlement that leaves you paying anywhere between 50 percent to 80 percent of your original balance.
Original Creditors
Original creditors, such as credit card companies, forgive debt when they fear not getting paid anything. If you file for bankruptcy, secured creditors get paid first from your assets or in a Chapter 13 repayment plan. If you don't have assets or have a lot of secured or nondischargeable debt, credit card and other unsecured debt is a low priority for repayment. Bankruptcy judges often discharge it entirely, so the creditor gets nothing.
Even if you don't file for bankruptcy, federal law obligates creditors to charge off your debt after six months of no payments. At that point, your account gets sent to a collection agency, which either buys the debt outright for pennies on the dollar, or takes a hefty commission from what it collects from you. Either way, your original creditor stands to lose a lot of money if it can't collect what it owes. If the creditor accepts what you can afford, it reduces its loss.
Collection Agencies
Collection agencies are often even more willing to forgive part of your debt in return for payment. Some collection agencies pay as little as 5 cents on the dollar for old debt, so even a very low settlements are profitable. Plus, debt collectors often work on commission making them motivated to accept a lower payment in hopes of getting some of your cash.
Credit and Tax Consequences
Debt forgiveness has potential credit and tax consequences. If the forgiven portion of your debt is more than $600, the creditor must submit a 1099-C form to the IRS, and you may have to report it as taxable income. Some creditors report debt forgiveness to credit reporting agencies. This can end up on your credit report and potentially lower your score or scare off prospective creditors.
Warning
Beware of "debt settlement" firms that make big promises about all the money you'll save by working with them. They often can't do anything that you can't do for yourself, and they'll charge you fees for their services. Get any agreement to forgive your debt in writing before you send any money: You don't want to make a payment to a debt collector or creditor only to find out that you misunderstood the arrangement or that it won't honor its settlement offer.
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