If you’ve made poor credit decisions, experienced a financial disaster, or ran up a large amount of credit card debt in the past, then you might be familiar with debt settlement. There are many third-party companies that can help consumers settle their debt for pennies on the dollar. But, like most things, setting your debts has consequences.

A debt settlement is the process of negotiating a payoff with your creditor for less than the amount you actually owe. For example, if you owe a credit card issuer $10,000 on a Visa or MasterCard and the company agree to accept only $5,000 instead as payment in full for your debt, you’ve just settled the account.

You can settle debts with your credit card company and other lenders on your own. Or, you can hire a firm that specializes in debt settlement to handle the process for you. In addition to the company’s fees, you typically pay the debt settlement company one set payment each month, and they pay your monthly debts for you according to a repayment plan.

Using a debt settlement company allows you to make only one payment, and it may reduce the total annual interest rate that you pay on the debt. Or, you may be able to negotiate debt settlements yourself with your individual lenders.

What is a debt settlement?

With debt settlement, consumers are often able to reduce their overall debt and pay only a portion of what is actually owed to their creditor. When the consumer pays the agreed upon settlement, the lender will typically update the account on the consumer’s credit report to reflect a balance of zero dollars.

However, in addition to the zero balance, a notation is also usually added to your credit report which reads something like “settlement accepted on this account,” “partial payment plan,” or “settled for less than the full amount.”
Debt settlements are considered to be derogatory events by the credit bureaus and the FICO and VantageScore’s scoring systems. Debt settlements have the potential to inflict a large amount of damage to your credit scores, and they remain on your reports for seven years.

Why debt settlements are derogatory

There’s a lot of misinformation floating around the Internet regarding debt settlement. First, it’s important to understand that a settlement indicates a failure by the debtor to live up to their end of the lender/borrower agreement. Your credit score will take a hit by settling an account.

Events leading up to a settlement typically weigh on your credit score too. If you need to settle a debt, you’re most like having trouble paying your bills and debts. You may have missed a payment. You may have paid less than the minimum monthly payment to get by for a little while. Each of these events negatively impacts your credit score, and you lender reports these missed payments each month.

And, if one of your accounts is already in default, and being reported as such, then the account is already having a negative impact on your credit scores. But, settling the debt will cause more damage to your credit report. It might be minor at that point, but it will still impact your credit score nevertheless.

Upsides to debt settlements

Settlements certainly have their downsides. But, they can also have a pretty appealing upside as well. If your debts have already been sold to collection agencies and have turned into collection accounts, then settlements are likely a very smart option. But, you will probably have to settle with the collection agency instead of your actual lender though.

Here are a few reasons why settling your debt might be a great financial move:

1. Settlements save you money

If the account you’re settling is in collections, you should keep in mind that the collection agency or debt buyer purchased your original debt for pennies on the dollar. Despite the fact that you defaulted on potentially thousands of dollars with the original creditor, the collection agency didn’t pay your lender the actual default amount you owed when they bought your debt.

When you settle an account with a collection agency for less than the full balance, you are saving yourself money and helping the collection agency to make a big profit. In this case, settlement can be a big win for everyone involved.

2. Settlements stop collection attempts

When a creditor or collection agency agrees to accept a settlement on your defaulted debt, they must also agree to stop pursuing you for the remaining, unpaid balance of the debt. Settling an account can help you say goodbye to annoying collection calls and letters. When you settle a collection account, it may also protect you from the possibility of being sued.

3. Peace of mind

Settling your debt will most likely give you peace of mind. It will be another thing that you can put in the past and move on from in your life. It can be a new lease on life.

Make sure its reported to the credit bureau

After you agree to a debt settlement, you’ll want to make sure that the lender, collection agency, or debt settlement company reports the repayment to all three credit bureaus and the Fair Isaac Corporation that runs the FICO credit score. Sometimes, the credit bureaus or your lenders overlook updating your account.

It might show that the account is in collections. But, you’ll still want to ensure that it shows the account is closed and paid. It will hurt your credit score no matter what, but having an error on your credit history will continue to hurt years afterward if you do not stay on top of it. It’s better to ensure that the credit report is accurate now than fight with the credit bureaus years later.

Get it in writing

You must ensure that you get it in writing that your agreed upon payment of less than what you owe on the debt is considered payment in full. Do not take someone’s word over the phone that it will settle the debt in full. Get it in writing before you write a big check. You don’t want your creditors or a collection agency coming back after you for the balance later.

You’ll owe the IRS

Here’s the real kick in the pants after you debt settlement is all said and done. The United States Internal Revenue Service (IRS) looks at the forgiveness of loans as income. In essence, the lender gave you money to forgive a portion of your debts. You’ll owe taxes on that income even though you didn’t see a dime of it physically in your bank account.

If a portion of your debt is canceled or forgiven, you must include the amount that was forgiven in your gross income figures when you file your income taxes at the end of the year. If the amount is over $600, the lender or collection agency will provide you with a 1099-C form and also send a copy to the IRS.

Debt and its forgiveness seem to be another gift that keeps on giving. So, plan now how you are going to pay taxes on that increase in income at the end of the year.

A debt settlement is not for everyone. There are consequences to paying less than you owe to your lenders that will follow you for years. But, settling your debt can help you recover from poor credit decisions. It can help you begin to turn your life around after a financial disaster.

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