A debt settlement offer to pay off a credit card with less money than what you owe can seem like a gift. Settling a $6,000 credit card bill for $4,000, for example, leaves you with $2,000 in debt that you don’t have to pay.
Instead of being in perpetual debt and seeing on your credit card statement how long it will take to pay off the bill, you can get that debt out of your life.
Or so you think. While the debt will be gone and the creditor or collection agency will get off your back, agreeing to a debt settlement can lead to other problems. Among them are higher taxes, a big hit to your credit score for years, and having to come up with the money to pay the debt off in a lump sum.
For some people, a debt settlement may be the worst way to pay off their debt.
Debt settlement offers can be initiated by you or a creditor or collection agency. If you have a large amount of debt from a credit card company, you may get a letter from the company offering to settle the debt.
Two triggers that could move a creditor to contact you with a debt settlement offer are if you’ve missed making payments for several months and are delinquent on the account. If they believe you can afford your payments, they’re less likely to settle.
A debt settlement may be offered because the creditor believes it is its best chance to get at least some of the money owed from a client. Credit card debt is unsecured. Creditors can’t take your house or car if you don’t pay, and must sue you in court to garnish your wages. If you file for bankruptcy, they’re unlikely to get anything.
In a debt settlement, the creditor agrees to reduce the principal amount you owe if you pay a lump sum that’s less than what you owe. It can range from 40 to 80 percent of the balance. To the creditor, this lesser amount is better than nothing or sending a collection agency or lawyer after you.
If you get a debt settlement offer, know that it can be negotiated. You can also contact your creditor first and ask for a settlement, or you can hire a lawyer to represent you in one.
If you’re going to negotiate, it can help to have a financial hardship that you’re facing — such as a huge hospital bill or job loss. These can be signs that you’re unable to pay many of your bills, with a credit card bill being your lowest priority.
If the creditor won’t drop to a lower payoff and you pay the sum they propose, you may be able to get them to report your debt as “paid in full” instead of “settled.” Having a debt listed as “settled” can hurt your credit score for years.
Whether you negotiate or not, conduct the entire process in writing. Get all of the details in writing, such as the payment amount and due date. Don’t send any money until you get the offer in writing and have reviewed it, possibly with a lawyer. It’s a binding contract and you should read the terms carefully.
If you don’t want to negotiate yourself, you can hire a debt settlement company to negotiate on your behalf as an intermediary.
Instead of paying your credit card issuer, you pay the debt settlement company directly an agreed-upon amount each month and the company pays your creditor after reaching a settlement agreement.
Some of these companies, however, have been found to be scams, or at least not totally honest with consumers. The Consumer Financial Protection Agency filed a lawsuit in 2017 against Freedom Debt Relief, the nation’s largest debt settlement services provider. The suit alleges that Freedom charges consumers without settling their debts as promised, makes customers negotiate their own settlements, and misleads them about its fees, among other problems.
Some debt settlement companies may insist you must use an intermediary, when in fact you can contact a creditor yourself to settle.
Some of these companies advise people to stop paying on active accounts and to stop speaking with their creditors. Withholding payments to save up for a settlement can lead to interest and penalties.
Advance payment may be required by some debt settlement companies. The Federal Trade Commission forbids this and only allows money to be collected once a debt is lowered or settled.
If you’re happy with a debt settlement offer you’ve received, then you may want to proceed. But you should be aware of the downsides:
Taxable income: The first is that a forgiven debt of $600 or more is considered income, and added income is taxable. In the example that we started with of a $6,000 debt being lowered to $4,000, the $2,000 that isn’t repaid is considered taxable income. Filing for bankruptcy or proving insolvency if your liabilities exceed your assets are the only ways to avoid the taxation.
Credit score drop: Your credit score could continue to fall after a debt settlement. Paying less than the original amount of debt will be reported to the credit bureaus as a settlement, which can stay on your credit report for up to seven years. While a settlement is better for a credit score than having an account reported as unpaid, it’s almost as bad as having a bankruptcy.
Coming up with cash: Whatever payoff you negotiate, the creditor will want it in one lump sum. Getting $4,000 together to settle a $6,000 debt may be difficult. The due date will likely be soon.
High fees: If you’re working with a debt settlement company, expect to pay fees equal to 15 to 25 percent of the amount of debt settled.
Bankruptcy may be a better option: Debt settlement may be your last resort if you’re facing a hardship and debt you can’t see a way out of. Bankruptcy may be a better way out, however, as a way to release yourself from debt and start rebuilding your financial life. A bankruptcy can be listed on your credit history for 10 years, and could still require you to make payments toward debt.
Aaron Crowe is a journalist who specializes in personal finance. He has written for AOL Real Estate, HSH.com, US News & World Report, Wisebread, LearnVest, AOL Daily Finance, AARP, Wells Fargo, Allstate, the USC Marshall School of Business, and Credit.com, as well as other insurance, credit and investment websites. Check out his website at AaronCrowe.net.