Settling a debt for less than the full amount is usually reported to credit bureaus as “settled” or “paid for less than the full balance”. This can lower your credit score, making it harder to get new credit in the future. The notation can stay on your credit report for up to seven years.
Debt Settlement
Debt settlement can have several negative effects, including:
The forgiven debt may be considered taxable income by the IRS. You can be issued a “Form 1099-C” for cancelled debt, which can be considered taxable income to you in the your forgiven, which you might be added to your taxable income for the tax year the debt is forgiven. Consult your tax professional for potential tax implications in your particular situation.
Debt settlement companies often charge fees, which can be high, sometimes $500-$3,000, or more. Sometimes, the settlement company requires that their fees be paid in full before they send your first dollar to your creditors.
Even if the original owed amount is reduced, the amount you owe may increase because of late fees or penalties or interest.
The creditor may require you to close the account, which will result in losing access to that credit line.
Creditors are not legally required to settle for less than you owe.
You may end up with more debt than you started.
Debt settlement is sometimes mistakenly referred to as “debt relief”. It occurs when you and a creditor agree to settle debt for less than what you owe.
How does debt settlement work?
Debt settlement is the process by which your debts are settled for less than you owe. Though you can settle debts yourself, many borrowers hire a for-profit debt settlement company.
Here’s how it works:
A debt settlement company will ask you to stop making payments on your debts and instead funnel that money into an escrow account, which is a separate account set up by the settlement company. As your debts become increasingly delinquent, the settlement company will approach your creditor with an offer, using the money in the escrow account. Ideally, the creditor accepts the offer, with the thinking that some money is better than none. Then, your debt is cleared for the lesser amount.
Debt settlement isn’t free. Debt settlement companies may charge a fee of 15% to 25% of the amount you owe for each successful settlement. For example, if you owe $10,000 and the debt settlement company charges a fee of 25%, you’ll pay a $2,500 fee (in addition to the settled amount).
Risks of debt settlement:
Though debt settlement may sound promising, settling your debts can take two to four years, and there are serious consequences to falling that far behind on payments. You could also face pressure tactics from collectors. If you’re getting calls, the creditor also has the option of filing a civil lawsuit against you. As interest and fees from your creditors pile up, you’re reducing any potential savings that debt settlement promises.
There’s also no guarantee a company can settle your debt. Some of your creditors won’t accept a debt settlement offer or work with debt settlement companies. Any debts you successfully settle may further hurt your credit score, since settled accounts stay on your credit report for up to seven years.