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Debt settlement allows you to pay off your creditors for less than you actually owe. It could be a good strategy if you’re unable to pay your bills, but there can be negative consequences for your credit so it’s important to understand how debt settlement works and to consider alternatives.
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Credit cards come with some wonderful perks. From attractive rewards and fraud protection benefits to credit-building potential, it’s no wonder that average Americans carry around four credit cards in their wallets. But when credit card debt grows out of control, it can cause serious problems in your financial life.
If you feel like you’re drowning in credit card debt, you may wonder if there’s a way out. You may even wish for a way to pay less money than you owe to your card issuer and call it a day.
Believe it or not, paying less than the full amount you owe and having your card issuer forgive the rest is sometimes possible. It’s called debt settlement or debt relief.
Yet before you get too excited at the possibility of saving money, it’s important to examine the debt settlement process in detail. You’ll also want to consider the potential consequences of legally settling accounts for less than you owe.
Credit card debt settlement is an arrangement that lets you pay less than you promised to pay in your original credit card agreement.
For example, you might owe your credit card company $5,000 in charges, interest, and fees. If your card issuer agrees to accept only $3,000 and consider your debt satisfied, that’s debt settlement.
In general, a creditor won’t consider a settlement offer if you’re current on your bill. But if you’re behind on payments, the situation may change. Rather than risking the loss of its full investment (aka the money a creditor loaned you plus expected interest and fees), a creditor may try to recuperate as much money as possible with a partial settlement.
Debt settlement negotiations typically begin in one of three ways.
Regardless of which party initiates the offer, there are two ways to manage the process from your end. There’s a do-it-yourself version of debt settlement where you negotiate with the creditor or collection agency on your own. You can also hire a professional debt settlement company to negotiate on your behalf.
You can call creditors and third-party debt collectors yourself to try to work out reduced settlements. If you decide you want to negotiate on your own, here are some tips that may help.
If you’re successful, DIY debt settlement might save you money in the long run. Since you’re managing the process on your own, you won’t have the added fees a debt settlement company would charge you.
Debt settlement companies can negotiate with creditors and collection agencies on your behalf. But before you hire a debt settlement company or attorney, consider the following:
A good debt settlement company might be able to negotiate better deals for you than you can on your own (though there’s no guarantee). You may also save time and avoid some stressful situations by hiring a professional.
Debt settlement, whether you manage it yourself or work with a pro, comes with some attractive perks that could work in your favor.
Settling your debts might:
You shouldn’t consider the perks of debt settlement without also taking a look at the drawbacks.
Settlement can be an effective strategy with certain types of unsecured debt. For example, you may be able to resolve delinquent credit cards, medical bills, and other collection accounts via the debt settlement method.
But if you’re past-due on an auto loan or mortgage, the creditor can seize your collateral (aka your car or home) and sell it to try to recuperate its losses. Student loans generally can’t be resolved with debt settlement either. However, your lender may offer hardship programs or rehabilitation instead.
Traditional debt settlement involves making a big payment to a creditor that’s less than your total outstanding balance. In exchange for this lump sum payment, the creditor agrees to accept less than you owe to satisfy your debt.
In reality, you may not have the means to come up with this kind of money — at least not very quickly. After all, if you had access to large amounts of cash, you probably wouldn’t be behind on your bills in the first place.
Settled debt could have a negative impact on your credit reports and scores in a few different ways. First, a debt settlement company might advise you to stop making payments on your accounts. Those late payments could hurt your credit scores. Remember, a creditor generally won’t accept less than you owe if your bill is current.
Check out our guide to learn how to remove a late payment from your credit reports.
Next, your creditor may report to the credit bureaus that the account was “settled for less than the full balance.” This notation can be bad for your credit scores. However, if your scores were already damaged by negative credit history (late payments, collections, etc.), then adding a settlement to the mix may not have a noticeable impact.
Finally, when you settle for less your credit card company might opt to close your account (if it wasn’t already closed due to a past-due balance). A new credit card closure may increase your credit utilization ratio, and that’s often bad for your credit scores.
When you settle a debt, your creditor forgives the difference between the amount you really owe and the settlement amount you pay. So, if you pay $2,500 to settle a $5,000 debt, your creditor forgives the remaining $2,500 balance.
If your creditor forgives more than $600 in debt, the IRS may require the company to send you a cancellation of debt notice (Form 1099-C). And you’ll need to add the amount of forgiven debt to your tax return as “other income.” This means that you might owe more taxes (or receive a smaller refund) than you would have otherwise.
There is a chance to have this additional tax liability wiped out. If you’re insolvent — meaning your liabilities are higher than your yearly income — your tax preparer may suggest filling out IRS Form 982. Talk to a tax professional for individual advice and more information.
Debt settlement is one way to deal with out-of-control credit card debt. But it’s not the best choice for every financial situation.
Before you commit to professional or DIY debt settlement, here are four alternatives to consider.
You may be able to consolidate your debt with a personal loan, a credit card balance transfer, or a debt repayment service like Tally. If you can secure a lower interest rate with a new financing offer, it may reduce your monthly payment (depending on your new payment terms). A lower rate may also help you pay down your debt faster and save money on expensive interest fees.
Wondering about your options? See four ways to consolidate credit card debt.
When a job loss, illness, or other financial emergency makes it hard to keep up with your monthly payments, your creditor may be willing to offer you temporary hardship relief. A hardship program may include lower monthly payments or temporarily reduced interest rates to help you get back on your feet.
It’s best to reach out to your creditor before you miss a payment to learn if hardship relief is available. Even if your creditor offers a hardship program, it could include some unpleasant side effects like account closure or negative credit reporting. Be sure to ask questions and find out all of the details before you move forward.
Credit card issuers have instituted special relief programs for cardholders struggling financially due to the COVID-19 pandemic. If the coronavirus has affected your ability to pay your bills, learn about COVID-19 debt relief measures.
A credit counseling agency can try to negotiate lower monthly payments and reduced interest with some of your creditors. This option is called a debt management plan or DMP.
Most DMPs are not free. Even non-profit credit counseling agencies may charge startup fees and monthly fees of up to $30 or more for their services. The average debt management program also takes three to five years to complete and any credit cards you include in the plan will generally be closed.
When all else fails, it may be time to talk to a bankruptcy attorney about your debt. Bankruptcy can protect you from your creditors when you can’t afford your regular monthly payments.
Filing bankruptcy should usually be an option of last resort. Once you file, a bankruptcy can haunt your credit reports for up to 10 years. Learn about using credit cards to rebuild after bankruptcy here.
Now that you’ve studied the benefits and drawbacks of debt settlement, along with some alternative options, you should be able to decide if professional debt settlement sounds like a good fit for you. If you’re ready to move forward, the next step is to do your homework before you decide which debt settlement professional to hire.
Be careful not to choose a debt settlement company with a bad reputation. You can check with your state attorney general for complaints. The Consumer Financial Protection Bureau also recommends reaching out to your state’s bank regulator to verify that the debt settlement company you’re considering is licensed to do business in your state (if required).
Michelle Black is a leading credit expert, author, writer, and speaker with over a decade and a half of experience in the credit industry. She is an expert in credit reporting, credit scoring, financing (mortgages, credit cards, loans), debt eradication, budgeting, saving, and identity theft. She is featured monthly at credit seminars, podcasts, and in print. You can connect with Michelle on Twitter (@MichelleLBlack) and Instagram (@CreditWriter).
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