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If you’re struggling with mounting debts that seem impossible to pay off, debt settlement can be an attractive option. After all, it promises to reduce your debt load and get you out of the red in no time. But before you sign any documents or hand over any money, it’s important to understand the potential pitfalls of debt settlement. Let’s take a look at some of the things you should be aware of before going down this path.
Debt Settlement Process
The process of settling your debts involves negotiating with creditors to reduce or eliminate the amount that you owe them. Generally, if a creditor agrees to settle your debts for less than what you originally owed, then the difference between the original amount and agreed-upon reduced amount is forgiven by the creditor. In other words, instead of owing $10,000 on a credit card balance, you could potentially negotiate down and owe only $5,000 on that same balance.
There are certain criteria that must be met in order for a creditor to agree to settle your debts. For example, if you can show proof of financial hardship (such as job loss or medical bills), then your chances of successfully settling your debts increase significantly. Additionally, it’s important to note that any settlements will be reported as such on your credit report and will remain there for seven years after the date of settlement. This could potentially affect your ability to obtain credit in the future.
Risk Of Lawsuits
One of the risks associated with debt settlement is that creditors may decide to sue you in order to collect what they are owed. This is especially true if you owe a substantial amount of money. In some cases, creditors will agree not to sue if you make an agreement with them for a negotiated lump sum payment or reduced payment schedule. Credit Card companies for instance start making the decision to litigate (sue) when the unpaid balance is 180 days or longer past due. The decision depends upon the account balance, level of delinquency, and estimated likelihood of payment (based on assets and employment income they are aware of). So, your chances of being sued increase if you have an account balance, you recently defaulted on your payments, and there is proof that you own assets and have a substantial income. Recoveries through this method take time and money though so creditors are much more open to coming to a negotiated agreement.
Credit Score Impact
Another potential pitfall of debt settlement is that it can negatively impact your credit score. When a creditor agrees to settle your debt for less than what is actually owed, they must report this information to the major credit bureaus. This information will remain on your credit report for seven years and can significantly lower your credit score during that time frame. Additionally, if the creditor does decide to sue you, it will also have an adverse effect on your credit score due to the negative information appearing on your record as part of the lawsuit proceedings.
Income Taxes!
One of the lesser discussed pitfalls is that of Income Taxes. If more than $600 is forgiven then the creditor is supposed to send you a 1099-C in the mail. If a creditor has discharged a debt you owed, you are required to include the discharged amount in your income, even if it is less than $600, on the “Other income” line of your Form 1040 or 1040-SR. However, you may not have to include all of the canceled debt in your income. There are some exceptions and exclusions, such as bankruptcy and insolvency.
Creditors however sometimes fail to send a 1099-C to debtors on discharged debt. The IRS will generally find this and send a letter of tax deficiency imposing taxes and penalties which can be costly. It is best to speak to a tax advisor if you have any questions on your discharged debt and be sure to include in your income in the relevant year.
