Whether you have experienced a job loss, an illness, or just made some plain old-fashioned bad financial decisions, you may find yourself in the all too common situation of having more credit card debt than you can afford to pay. If you are currently being crushed by a mountain of debt then you need to come up with a plan to fix the problem, sooner rather than later. One such plan is a process called debt settlement. And while settling your debts could save you a ton of money, there are certainly some downsides to the strategy.
Debt Settlement Cons
Credit Score Impact – When you enter a debt settlement agreement with a creditor or collection agency, the balance on the account will be updated to zero on your credit reports and the account will be notated as “settled for less than full balance.” Accounts reported as “settled” rather than “paid” may have a negative impact on your credit scores, possibly even a significant one. However, if you already have multiple issues with collection accounts or accounts in a defaulted status on your credit reports then any additional negative impact caused by a settlement could be negligible.
Zero Balance Collections – If you settle a collection account and it is updated to a zero balance then you may be surprised and disappointed to learn that the account still has the ability to negatively impact your credit scores. The vast majority of credit scoring models currently used by lenders are far less concerned with the balance of your collection accounts than they are with the fact that collection accounts occurred in the first place. Additionally, collection accounts are permitted to remain your credit reports for 7 years from the date of default of the original account so, settled or not, a credit card collection has the potential to inflict damage on your credit scores for a very long time.
Tax Implications – Once you finish your debt settlement there is a very good possibility that you will receive a 1099-C tax form in the mail at some point in the future from the creditor with whom the settlement was made. The amount of forgiven debt must be included on your tax return as income and, as a result, there is a very real possibility that you could find yourself paying additional taxes.
Debt Settlement Pros
Saving Money – Obviously the biggest advantage to settling a debt with a creditor or collection agency is the fact that you have the ability to satisfy an outstanding debt for only a portion of what you actually owe. All settlements are unique but you could find yourself paying only a fraction of what you actually owe.
Credit Score Impact – As mentioned above, settling a debt is typically viewed as a negative event by credit scoring models like FICO and VantageScore. However, settling outstanding credit card debt can have a positive impact on your credit scores as well because in the newest version of the aforementioned credit scores collections that have a zero balance are ignored.
Peace of Mind – Perhaps the biggest benefit to settling your defaulted credit card debt is relief. Once a debt has been settled you no longer owe the creditor any money. That means no more collection calls or letters. Plus, if a debt has not yet been “time barred” and you are still within your state’s window for being sued, settling a debt in full can remove this worry from the back of your mind as well.
Good article. The only thing I suggest be added is: If you have a negative net worth at the time you settle your debt, you will NOT have to pay taxes on the settlement. You will have to file IRS form 982 to let them know you were “insolvent” at the time of the settlement.