If you are deep in debt and unable to pay, you may have considered debt settlement as a way to get out of debt. In debt settlement, your creditor agrees to accept less than the amount owed as payment in full. If you don't have problems paying your bills, it may be tempting to try to save money by negotiating a debt settlement with your creditors. While you can save some money settling debts, the practice has some pitfalls you should consider.
Credit Damage
For a creditor to consider settling a debt for less than what you owe on the account, you generally must be past due on your debt payments. A creditor has no interest in accepting less than what you owe if it believes that it can collect the full balance. If you are current on your debts, you need to become past due by skipping payments to put yourself in position to negotiate a settlement. Becoming past due will damage your credit rating, and debts listed on your credit report as settled for less than you owe also cause your credit score to drop.
Tax Implications
If you settle debts for less than you owe, the forgiven portion of the debt is considered income by the Internal Revenue Service. The creditor that accepted the settlement will send you a form 1099 that will list the amount of forgiven debt. You need to report this on your form 1040 as taxable income and pay any taxes that are due. Although this reduces the benefit of debt settlement, it does not eliminate it. If you are in the 28 percent tax bracket and settle $20,000 in debt for a $10,000 payment, you will owe $2,800 in taxes, but you will have saved $10,000 on the debt payoff.
Promises Broken
When you sign an agreement to pay a debt, you have given your word that you will pay it as agreed. Sometimes things happen that make it impossible for this to happen. In these cases, most people can make a moral case for debt settlement. However, a person may have a problem intentionally becoming past due on a debt to settle the debt for less money than what he owes when he is capable of paying the bill as agreed.
Other Options
If you are able to pay off your debts in full over time, you may want to establish a written budget and develop a plan that will allow you to pay off all debts within a fixed amount of time. If you need to make monthly payments to creditors to pay off the debt, you may want to attempt to negotiate a reduction in interest rates rather than a reduction in the balance. You can often negotiate a reduction in the interest rates on your balance if you agree to close the accounts. This may be a better option, as it is not as likely to damage your credit.
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