If your creditors stop receiving regular payments from you and you are in danger of defaulting on your account balances, your creditors might negotiate a settlement balance with you in order to minimize financial losses. From a creditor's perspective, recovering a portion of the debt you owe is better than recovering nothing at all. While settling your debts may be necessary in certain circumstances, doing so can carry negative consequences.
Tax Issues
By paying less to your creditors than you actually owe and settling your outstanding accounts, you free up money to apply to other debts -- helping you get back on your feet financially. The creditor then forgives the portion of your debt that you leave unpaid. Just because the creditor forgives the debt, however, that does not mean that it disappears.
When your creditor files its taxes, it writes off your settlement's unpaid balance as a loss. The IRS classifies the amount written off as "discharge of indebtedness" income, and you must count as income and pay taxes on whatever debts your creditors forgive during a settlement. Doing so could increase your tax bill or decrease your tax refund.
Credit Consequences
Creditors don't agree to settle consumers' accounts merely because the consumer makes the request. A creditor only agrees to a debt settlement if the alternative is receiving nothing. Thus, few creditors -- if any -- will settle your debts without you being late on your payments. Each time you miss a payment, however, the company reports this fact to the credit bureaus. It appears on your credit report and your credit score drops considerably as a result.
When you actually settle the debt, this fact also appears on your credit report. If the debt in question is particularly old, settling the debt adds a new feature to the account's trade line on your credit report, updating it. Because recent credit entries are more significant to the credit scoring formulas than older items, settling old debts can also lower your credit score.
Collection Debts
Collection agencies purchase accounts that consumers leave unpaid and then collect the debts themselves. Unless you request a statement from the collection agency noting that the company intends to forgive the remaining balance you owe, the collection agency can sell your settlement balance to another collection agency that will then contact you demanding payment in full for a debt you thought you'd previously settled.
Settlement Solutions
You can settle your debts with as little risk as possible provided the debt settlement is necessary for your financial stability and you obtain any agreements you make with the creditor in writing before paying the agreed upon amount. Settling debts yourself, if possible, is always preferable to hiring a third-party company to negotiate with a creditor on your behalf. The Federal Trade Commission warns than debt settlement companies charge considerable fees for their services -- often requiring a flat fee and a percentage of the amount you saved through the settlement. Thus, if saving money is your ultimate goal, debt settlement carries the greatest benefit if you conduct the negotiations yourself.
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