Debt settlement is not the same process as debt consolidation. With consolidation, you combine multiple debts into one lump sum and take out a loan to pay them all off at once. When you settle a debt, you’re paying a percentage of what you owe, not the entire balance.
By KEVIN FLYNN
Based on that definition, settlement seems like a better option because you end up paying less. That’s usually true, but there are other costs associated with it. Some of them are financial and others affect your credit score. It’s important to understand all the risks.
#1: Your credit score will go down
Asking your creditors for a settlement usually involves missing a payment or two before they’ll negotiate. You need to show that you’re unable to meet your minimum monthly payments. If you go to a settlement agency, the first thing they tell you to do is stop paying your credit cards. This might get you a settlement in the end, but your credit score will take a hit.
#2: Penalties and interest still accrue
While the settlement negotiations are in progress, interest and penalties continue to accrue, so your debt is still going up. While you’re missing payments and waiting for the creditor to come to the table, it’s costing you money. Should the creditor refuse to settle, you’ll end up with a much larger debt. Keep this in mind before you choose to go this route.
#3: No guarantee of acceptance
As stated above, your creditor is not obligated to offer or accept a settlement. They have other options, like taking you to court or asking for a lien on your wages or property. Legal action is generally more expensive for them, so the settlement is more likely, but it’s not guaranteed. Be cautious about settlement agents who tell you that it is.
#4: Debt settlement fees
Debt settlement agencies charge fees—that’s how they make their money. They’re not allowed to charge upfront fees, but they will usually charge a percentage of either settled debt or eliminated debt. Either way, you could end up paying significantly more than expected. Read the fine print on any contract with a settlement agency before signing up.
#5: Charge-offs may be taxable
When you owe $10,000 to a creditor and they settle for $6,000, you’re not completely off the hook for the remaining $4,000. The creditor will write it off as a “charge-off” and may send you a 1099-C for it. The government treats forgiven debt as income, so you’ll have to pay taxes on that amount. These numbers begin to add up when you consider the settlement amount and any fees you pay the agency.
Alternatives to debt settlement
It’s okay to try for a debt settlement if you understand the risks involved, but it’s not your only option. You might want to try applying for a debt consolidation loan first. The money you save on interest could add up to the same amount or more than what you save by settling. You could also file for bankruptcy, but that affects your credit for several years and isn’t always the best alternative.
Whichever path you choose, research the pros and cons of it. We’ve just outlined five risks of debt settlement, but it also has some benefits—namely, you’ll be out of debt once the settlement is made, and you will have paid any outstanding taxes and fees.
Kevin D. Flynn is a former fintech coach and financial services professional. When not on the golf course, he can be found travelling with his wife or spending time with their eight wonderful grandchildren and two cats.