Negative Effects of Debt Reduction

Debt reduction accomplished by simply paying bills on time is a good thing. However, using other strategies for debt reduction often causes many negative effects. It can take two to three years for a debtor's credit rating to fully recover from debt reduction. The overall effect of debt reduction is even broader, with some people intentionally harming their credit scores for several months before qualifying for debt reduction through special programs. If possible, debtors should avoid debt reduction programs that harm credit.

Debt Settlement

Debt settlement reduces debt by allowing debtors to pay off balances for less than the full amount. Settlement is possible on unsecured loans such as credit cards. Savings through settlement are sometimes impressive. SmartMoney.com reports that some creditors will settle unsecured debts for 20 to 75 percent of the balance. The drawback is that settlement is usually available only after accounts are three months past due, or longer. That's a big negative effect because the debtor's credit score could drop with each missed payment. Creditors will not settle an account that is current because they have no reason to do so.

Bankruptcy

Bankruptcy is the most effective method for debt reduction, but it is also the most damaging to credit. Bankruptcy information remains on credit reports for 10 years. That makes it very hard to obtain credit at reasonable interest rates for at least the first two or three years after completing the bankruptcy. There are other negative effects as well. Potential employers conducting credit background checks may refuse to hire people for certain jobs if they have a bankruptcy history. Also, bankruptcy filings are open to the public, meaning a neighbor or co-worker could obtain a copy of a debtor's bankruptcy filing.

Tax Implications

People who reduce debt through settlement could also face higher tax bills. The Internal Revenue Service treats savings through debt settlement as income in most cases. A debtor settling $40,000 in credit card debt for $10,000 must report the difference of $30,000 as income. People suffering from insolvency at the time of the settlement can apply for an exemption allowing them to escape a higher tax bill, but not everyone will qualify. Insolvency means a person has more debts than assets.

Credit Reports

A debtor's credit report will show the entire timetable for debt reduction. The report may show late payments, charge offs, collection accounts, and accounts listed as "settled for less than the full balance," or a similar description. A charge off is an account a creditor deemed noncollectable. A collection account is an account sold or transferred to a debt collector. Together, all the negative information makes it very difficult for a debtor to qualify for credit at competitive interest rates for several years.