Negatives of Settling Debt

Borrowers who find themselves unable to meet their obligations may consider settling their debts with their lenders. Debt settlement is a process whereby you negotiate with your creditors an amount to pay them to satisfy the loan. The amount that you are able to negotiate depends on your lender, but can be as little as 50 percent of the amount you owe. Settlement is generally an option for unsecured debt, such as credit cards and personal loans, and does have some negative consequences.

Fees

As of 2010, settlement companies can no longer charge an up-front fee for their services, but the fees can still be substantial. The Federal Trade Commission requires that providers who settle multiple debts for a consumer prorate the fee per settlement to keep it proportional to the total fee of settling all debts at once, but settlement companies will still charge fees to establish an account, monthly service fees and a percentage of the amount they save you. According to the United States Government Accountability Office, a company in Arizona advertised its successful settlement of a New York couple's debt although by the time the company added its fees to the settled amount, the couple paid more than 140 percent of the original amount of the debt.

Scams

According to the U.S. GAO, FTC and state investigators have found that more than 90 percent of consumers do not successfully complete the programs that settlement companies offer, even though the company may advertise high success rates. Some settlement companies claim that they are providing services for government programs even though there are no government programs for debt settlement as of 2010.

Credit Rating

Since most lenders will not negotiate a settlement until the consumer is behind on payments, you will be reported to the credit bureaus for late payments and nonpayment. If a settlement is made, the debt may show on your credit report as settled for less than owed, which will further damage your credit rating. Your credit rating controls your future ability to receive credit offers and the interest rates you will pay for credit. A low rating can make it very difficult to obtain credit.

Tax Consequences

The IRS considers any amount of debt that is forgiven or written off by the lender to be income to you. The lender will send you a Form 1099-C that lists the amount of the canceled debt. You must declare this amount as income and pay the appropriate taxes on it. Consult a tax professional advice about the insolvency exemption to this rule.

Alternatives

Alternatives to debt settlement include contacting your creditors to work out a modified payment plan, credit counseling, debt management plans and bankruptcy. If your inability to pay is temporary, receiving a modification may be your best option. If it is not temporary, you must analyze your situation to determine your best course of action.