A debt settlement is an agreement between a borrower and a lender which allows the borrower to repay the lender less than the amount owed to resolve the debt. This might sound like a good way to pay off all your debts and quickly improve your financial situation, but it can actually do more harm than good. Let’s take a look at the pros and cons of debt settlements.
How Debt Settlements Affect Credit History and Credit Scores
The Argument for a Debt Settlement
Late payments or non-payment decrease your credit score. Consumers considering debt settlements often argue that their credit scores and credit history are already taking a beating, since they’re struggling to pay their debts on time. This is true. If you are looking to do a debt settlement because you can’t keep up with your monthly payments, then you are already experiencing notations on your credit report that say you pay your accounts late, and your FICO score is already decreasing as a result.
If a debt settlement will free up enough cash flow to enable you to make the rest of your payments in full and on time, then you may be able to start working toward a better credit score right away, as your new credit history will reflect on-time payments rather than late payments. Keep in mind, it will still take several years for your credit score to recover.
Dangers of Debt Settlements
Debt settlements can help consumers get out of debt more quickly, but they can have very bad consequences. For example, a debt settlement is reported to the credit bureaus and appears on your credit report, resulting in a huge drop in your FICO credit score and it can also affect your taxes.
A debt settlement can hurt your credit score. A debt settlement can reduce your credit score by as much as 125 points. This is a big hit to absorb all at once and may be difficult to recover from quickly in the event you need a high credit score for some purpose — a mortgage, a new credit card — in the future.
Taxes. A debt settlement can result in a large tax bill when you file your income taxes because, in many situations, the IRS treats the amount of the forgiven debt as income and requires you to pay income tax on it. So, if you owed $10,000 to a creditor but they agreed to settle the debt for $5,000, you could be looking at an increase of $5,000 to your taxable income. If you meet certain criteria, you do not have to pay taxes on the debt settlement amounts as income, but it’s something you should consider before agreeing to settle any of your debts.
Credit history. On your credit report, a debt settlement will appear for seven years from the original delinquency date of the debt. Other lenders will look at that notation negatively, and it may stop them from lending money to you in the future. A lower credit score can make it difficult or impossible to borrow money and can result in an inability to rent an apartment, increase car insurance premiums and even cause denial for job opportunities.
Final Notes on Debt Settlements
Get it in writing. If you agree to settle a debt, make sure you get the arrangements spelled out in writing before you send money. The agreement should tell you how much the original debt is, how much the creditor is willing to accept to settle the account and how it will be reported to the credit bureaus.
Other options. If you decide a debt settlement isn’t your best option for getting out of debt, you have other choices:
- You can remain delinquent on your accounts, paying when you can, and hope your situation improves so you can pay off the debts at some point.
- You can find a way to earn extra money in order to pay debts off faster.
- You can get credit or debt counseling.
- You can file bankruptcy.
None of these actions should be taken without fully considering the potential results of your actions. Your credit score is important; you don’t want to ruin it.
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