The Dangers of Debt Settlement

Be careful if choosing debt settlement to handle your debt.

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You may have read about debt settlement as an alternative to bankruptcy or an easy solution for resolving your ever-growing debt. The ads sound especially promising and usually read something like "Reduce your debt up to 65 percent!" or "Get out of debt in less than six months!"

Debt settlement companies promise to reduce your debt by negotiating with your creditors, but the potentially negative effect it has on your credit score isn't explained quite so clearly. If you're considering debt settlement as a solution to debt problems, get the full story first.

How the Process Works

The process starts when you call a debt settlement company and tell them about your situation. You give the names of the creditors and the amount you owe. The debt settlement company then gives you an estimate for reducing your debt along with a new, lower monthly payment. As advised by the settlement company, you stop paying your creditors and instead send payments to the debt settler.

The debt settlement company puts your monthly payments into a savings account. Once the account has grown to a certain amount, the debt settlement company calls your creditors and begins negotiating a settlement. The settlement is an amount lower than your full outstanding balance.

If your creditors agree to a settlement amount, the settlement company pays the creditors and takes a fee for the work of negotiating the settlement. This could be a flat fee or a percentage of the debt that was canceled.

What's so Bad About Debt Settlement?

On the surface, debt settlement sounds great. You pay the debt settlement company who, in turn, pays your creditors. In the end, everyone gets paid and you're able to move on with your life. However, remember the part where you stopped payment to your creditors while the settlement was being negotiated? That's the part that will come back to haunt you.

Creditors don't typically settle debts unless they're a few months past due. That means you have to stop paying your accounts and allow them to become past due.

Meanwhile, your late payments get reported to the credit bureaus, your credit score drops, and you might begin receiving collection calls. Regardless of the debt settlement action, those late payments remain on your credit history for up to seven years. Until you start accumulating positive credit activity, you'll have difficulty getting new credit cards and loans. You may even find your credit score interfering with getting a job or a good insurance rate.

If the debt settlement company successfully settles with your creditors, the delinquent information isn't erased from your credit report. Instead, your account is updated to something that shows you settled, such as "Charged-Off Settled" or "Paid-Settled." A settled status isn't nearly as good for your credit score as a "Paid in Full" account.

The Fallout

After debt settlement, it may take a few months or even a few years to rebuild your credit and get approved for unsecured credit. You could also owe taxes on settled debts. The Internal Revenue Service (IRS) treats forgiven debts as income and expects you to pay income taxes on the forgiven amount.

Creditors are supposed to send you a Form 1099-C for reporting canceled debts, but the IRS expects you to include the debt on your tax return even if you don't receive the form.

Alternative Solutions

If you're current on your accounts, or even just one or two months behind, and you want to maintain a good credit score, then debt settlement is not for you.

Consider consumer credit counseling, which helps you enter into a debt management plan with your creditors. There's a possibility of reducing your monthly payments, and you'll still be able to pay your balance in full, which is reflected on your credit report. As long as you make your payments on time each month, consumer credit counseling does not hurt your credit.

You can also work out your own payment plan with your creditors. If you've missed one or two payments, ask your creditors if they have a hardship program for customers who are having financial difficulty. Tip: use the word "hardship" in your conversation. You can often get help in the form of a temporary reduction, for six months to one year, in your monthly payment and loan or credit card interest rate.