Settling your debts can be a way to save a significant amount of money on the total that you owe. At the same time, you may want to take into consideration what a settlement could do to your credit. This solution is often promoted by debt relief companies, but it could potentially do more harm than good.
Debt Settlement
Debt settlement is a process in which you negotiate a lump sum payment with a creditor. You could also hire a lawyer or debt relief company to do this on your behalf. You agree to pay a lump sum that is less than the total amount of debt. Your creditor agrees to close out your account and will write off the remainder of the debt. In some cases, you may be able to make installment payments for a few months and still get some of the debt forgiven.
Lower Credit Score
One of the most negative effects that comes with settling your debt is the lowering of your credit score. When you settle your debt, the creditor will report that your account has been "settled" instead of paid. This event can lower your credit score by as much as 125 points in some cases. Anytime that a creditor looks to your credit report, they will see that you settled a debt. This can negatively affect your ability to obtain additional financing in the future.
Tax Implications
Besides damaging your credit score directly, a debt settlement can also increase your tax liability. When the creditor settles your account, it writes off the rest of your debt. This results in you receiving extra income according, to the Internal Revenue Service. You have to add this to your taxable income and it will also add to your tax liability. If you cannot pay your taxes, the IRS can place liens on your property or levy your assets. The IRS can also garnish your wages until the debt is repaid.
Fixing the Damage
Although settling your debts can significantly damage your credit score, it is not a permanent mistake. You can take the necessary steps to rebuild your credit and make yourself an attractive borrower again. You can start out by opening another credit account, such as a credit card or store account. Then you can charge small purchases on the credit and pay them off as soon as you receive the bill. The timely payment history will reflect positively on your credit profile. Paying down any other credit balances that you have can also help improve the credit score damage.
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