If you can't afford to pay off your entire debt, you may be able to negotiate a debt settlement. With debt settlement, your creditor agrees to allow you to pay off your entire debt with one lump sum payment that is less than the amount you owe. Occasionally the creditor may agree to a payment plan as well. You can choose to negotiate directly with your creditor, or you may hire the services of a debt settlement firm. The dangers of debt settlement include long-term credit ramifications and possible legal action.
Credit Ramifications
In spite of some advertising claims, debt settlement is usually destructive to your credit. Many debt settlement firms suggest that entering into a payment plan is a good alternative to bankruptcy, because bankruptcy is so damaging to your credit. However, entering any type of debt settlement plan is a major negative item on your credit report, as it shows lenders you are willing to pay back less than you owe.
Legal Action
If you work with a debt settlement firm to reduce your outstanding debt, your creditors do not have to accept your plan. What they must do is provide accurate credit information to the credit reporting agencies. Debt settlement firms often hold customer funds in a type of savings account, or worse, they may withdraw fees from your payments before sending any money to your creditors. As a result, if you start making payments to a debt settlement firm instead of directly to your creditors, you most likely will produce a record of late payments to your creditors. After a certain amount of time, this can lead to your creditors suing you for non-payment, even if you are working with a debt settlement company.
High Fees
Debt settlement firms typically do not offer their services for free, and, in some cases, the fees can be high. In spite of regulations implemented by the Federal Trade Commission, some settlement firms charge fees before they send your money to your creditors. Additionally, if you stop paying your creditors while working with a debt settlement company, your creditors may impose late fees, penalties, additional interest, and over-the-limit fees on your original debt, if applicable.
Taxation
Perhaps the most surprising feature of debt settlement is that even if you successfully settle your debt, you may have another bill due. The IRS views most types of cancelled or forgiven debt as taxable income, meaning you will generally owe tax on the amount by which your creditor reduced your debt. For example, if you owe $100,000 in debt and pay off only $60,000 through a debt settlement program, that $40,000 in forgiven debt is taxable income. When you combine the added taxes with the fees and expenses from both your creditor and the debt settlement company, your total financial benefit from the debt settlement plan may not add up to as much as you originally planned.
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