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Does Debt Settlement Work?

For better or worse, debt settlement is all the rage these days. The New York Times wrote yesterday about a debt-ridden freelance writer who settled a $5,000 credit card debt for half of the original balance. The Today Show discussed debt settlement on its program this morning. What is debt settlement? Does it work? And what are the consequences of settling a debt for less than you owe?

What is Debt Settlement?

Debt settlement is the process of negotiating with creditors (usually credit cards) to pay less than you owe to discharge the debt. For example, if you owe $8,000 on a credit card and have fallen months behind in payments, the credit card company may allow you to pay 75% or even 50% of the balance and call it even (i.e., forgive the remaining debt). To qualify for a debt settlement arrangement, the creditor may require you to have the settlement amount in a lump sum or pay it over a short period of time (usually less than a year). Although credit card companies almost never settled debts in the past unless a debtor was declaring bankruptcy, times have changed. With so many people behind on their bills these days, credit card companies are finding that getting something is better than nothing.

Warning! Debt settlement is something that some people can do for themselves by being persistent and working with creditors directly. There are hundreds of companies that advertise debt settlement services and promising to cut your debt in half, etc. These companies charge hefty upfront fees (often 10-15% of what you owe) and cannot guarantee results, no matter what they say. Stay away. If debt settlement could work for you, you can do it yourself!

The Consequences of Debt Settlement

First of all, settling a debt will ruin your credit. Although banks probably won’t agree to consider debt settlement unless you are already significantly behind on your payments (at least two months), a settled debt may appear on your credit report as a charge-off, which is far worse for your credit than a few months of late payments. (In general, you can reverse the damage done to your credit by a few late payments with two or three years of timely payments; a charge off will continue to haunt you for up to seven years). Although not as bad as bankruptcy, settling a debt will impair your credit for a long, long time.

Second, creditors must report canceled debts to the IRS using form 1099. So if a credit card forgives $2,000 of your debt, you may owe taxes on that $2,000 just as if somebody wrote you a check for the amount…unless you can prove that you are insolvent. There is an “insolvency” rule in IRS Publication 908 that governs taxes and bankruptcy. Even if you’re not filing bankruptcy, if you owe more money than you have (i.e., have a negative net worth), you may qualify as insolvent and may not have to pay taxes on forgiven debts. That said, if you settle a debt you should definitely seek professional help with your taxes that year.

The Bottom Line: Is Debt Settlement Worth It?

If you’re drowning in debt, debt settlement may be able to get you out from under your debt for less than you currently owe. If you have some money stashed away and have already ruined your credit (or aren’t worried about ruining your credit), then it’s a viable option. To get started, call your creditors (or wait for them to call you; if you’re late, they will). Ask them vaguely if there is any way they might be able to reduce the amount you owe if you can come up with a full payment quickly. Yesterday’s times article indicated that at some credit card companies, it doesn’t even require a supervisor to get the debt settlement ball rolling. Reps at other banks may not be able to help, so you’ll have to ask for a supervisor. Be persistent, and negotiate. If they offer to settle your debt for 80%, tell them you’d consider 50% and go from there.

Need help with debt? Get a free debt consultation now.

Published or updated on June 17, 2009

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.


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