Find out whether settling debt helps or hurts your credit and finances in the long run.
Many people are tempted to settle an old debt for less than they owe, but they’re unsure about how it would affect their credit. Deanna T. asks:
“I don’t have a huge amount of debt, but it’s killing my credit score and I want to get rid of it. Is it better to pay old credit card debt in full or to settle it for less?”
What is Debt Settlement?
Debt settlement is the process of making a large, one-time payment toward a debt in exchange for having the balance of the debt forgiven.
For instance, let’s say that Deanna has $6,000 in credit card debt and she hasn’t been able to make minimum payments for many months. The credit card company may approach Deanna, or she could contact them, about settling the debt for $3,000 and canceling the remaining $3,000.
How much you can settle a debt for is always negotiable and the higher your balance the bigger the discount you’re likely to receive on a percentage basis.
Settlement is typically an option for unsecured debts, like credit cards and medical bills, that aren’t backed by collateral that could be seized by the creditor and sold to pay off the debt (as is the case with a car or home loan).
In general, an unsecured creditor would rather get a smaller upfront payment than risk getting no payments on the account.
Does Settling Debt Hurt Credit Scores?
If you have a lump sum of cash to make a debt settlement, paying less than you owe may sound like a dream come true! However, there are drawbacks to be aware of.
The first downside to settling a debt is that it shows up on your credit report. Any time you pay less than you borrowed (including interest) you damage your credit history and credit scores.
Negative information—like late payments or a settlement—remain in your credit file for up to 7 years from the original delinquency date. Making a payment or settlement doesn’t reset the clock and cause negative information to stay in your credit history any longer.
If your credit scores are already in the dump because you missed payments or the account was turned over to a collection agency, taking a settlement probably will have little or no additional negative effect on your credit scores.
Just remember that a settlement on your credit file looks bad to potential future lenders because it shows that you have a history of not paying back what you borrow.
Related Content: Best Tips to Improve Your Credit Score
Canceled Debt is Taxable
A second downside to settling debt is that you typically owe tax on any amount that’s canceled or forgiven. Creditors are required to report forgiven debt to the IRS, which means that you’ll receive Form 1099-C at the end of the year and must include the amount on your tax return.
So, even though Deanna wouldn’t have to repay the credit card company $3,000, she’d still owe Uncle Sam a big chunk of it, depending on her income and tax situation. The settlement saves her money, but means she might have to come out-of-pocket for an unexpected tax bill.
Related Content: What You Need to Know About Forgiven Debt and Taxes
Should You Settle Debt or Pay in Full?
If having good credit is your main priority because you want to qualify for a car or home loan in the future, paying off an old debt in full is the best option. For some, paying off debt as agreed is a matter of pride and ethics. But if your objective is simply to repay as little debt as possible, settling is the best route.
Related Content: Best Tips to Improve Your Credit Score
Don’t fall into the trap of mistakenly believing that if you don’t pay an old debt that it will just disappear. Nothing could be farther from the truth!
As I mentioned, unpaid debt gets wiped off your credit report after 7 years, but you still legally owe the money. Unless a debt is forgiven or discharged through bankruptcy, the creditor can attempt to collect from you forever.
However, a creditor can’t sue you once the Statute of Limitations for Debt has expired. This is a legal window that varies widely by state and by the type of debt. In general, it begins from the date of your last account activity. Therefore, in some states making a payment or settlement on an old debt can reset the clock on the statute of limitations.
Related Content: How to Deal with Debt Collectors
Tips for Settling Debt
If you’re considering settling an old credit card debt, here are 3 tips:
Get your agreement in writing. Never pay a debt settlement until you receive a signed agreement showing that your payment will satisfy the entire debt and that the creditor gives up their right to sue you for the unpaid portion.
Reduce spending on the card. A card company won’t view you as a customer who deserves their sympathy if your statements show that you’ve been splurging on spas or designer shops. Cut back or stop making charges on the card several months before you request a debt settlement.
Make a low initial offer. Start by offering to pay a dollar amount that’s about 30% of what you owe and expect the creditor to make a higher counteroffer.
If a creditor doesn’t agree to a debt settlement, ask about other opportunities to save money. For instance, request that they reduce your interest rate, lower your monthly minimum payments, or allow you to temporarily stop making payments.
If you have access to cash to make a debt settlement, think carefully about the best way to use it.
You may need the cash for everyday living expenses, or consider using it to file for bankruptcy instead, if your financial situation is really dire.
On the other hand, spending cash to pay off debt at a huge discount could make sense if your financial situation is starting to improve.
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