by Odysseas Papadimitriou. CardHub CEO
Credit card debt settlement is an agreement between an indebted consumer and a creditor that entails the consumer submitting a lump-sum payment for the majority of what they owe in return for the company that owns the debt forgiving part of the outstanding balance as well as certain fees and finance charges.
Unfortunately, the need to settle debt arises far too often. Consumers consistently spend beyond their means and eventually see their balances spiral out of control when interest charges and fees become unsustainable.
“Credit cards have two properties that can prove irresistible to consumers,” says Michael I. Norton, associate professor of business administration at Harvard Business School and co-author of Happy Money: The Science of Smarter Spending. “First, they allow us to have nearly anything we want right away. … Second, they reduce what researchers call the ‘pain of paying.’ Forking over cash is painful because it makes the loss so salient, whereas credit cards make everything feel ‘free’ since the actual payment happens months after the purchase.”
Settling amounts owed is one way to escape serious credit card debt, but it’s neither the only one nor is it without its own perils. Not only do a lot of shady companies operate in the debt settlement space, but debt settlement and the circumstances that bring it about can also be detrimental to your credit standing .
We’ll explain these issues in further detail below:
How Does Debt Settlement Work?
First of all, it’s important to note that credit card debt settlement is only a viable option if you have already defaulted on what you owe or are close to doing so (i.e. you’re experiencing serious financial hardship). In other words, you have to be around 180 days behind on your credit card payments to even qualify for consideration.
With that said, there are two basic types of debt settlement: 1) do it yourself debt settlement ; and 2) service-assisted debt settlement. You can also attempt to settle the following types of debt:
- Credit card debt
- Store card debt
- Unpaid medical bills
- Unpaid phone bills
The fundamentals, however, are the same regardless of which type of debt settlement program you choose or what type of debt you’re trying to settle. Basically, the debtor approaches the creditor with a partial payment offer (anywhere from 30-80% of the full amount owed) and asks that the remaining amount be forgiven. The creditor can then accept, reject, or counter this offer.
Once both parties agree on a settlement amount, the party that owes the money will be required to submit the respective lump-sum payment within a specified timeframe. Doing
so will satisfy and officially close the account in question. Not doing so will likely increase the odds of the creditor suing for the full amount owed.
Tax & Credit Score Implications:
Anyone contemplating a debt settlement must also factor potential tax obligations into their budget, as creditors are legally required to report forgiven debt (excluding forgiven fees and finance charges) to the IRS, which considers it to be income since you’ll have technically borrowed the forgiven amount without paying it back. You are therefore likely to receive a 1099-C form in the mail after a debt settlement agreement goes through, so make sure not to discard any communications from the IRS.
Let’s say, for example, that you defaulted on $1,500 in outstanding credit card debt – $500 of which is fees and finance charges. If you reach a settlement agreement that requires you to submit an $800 payment, the $200 in forgiven principal will be taxable. If you’re in the 25% tax bracket, you’ll therefore owe $50 to the IRS, meaning your settlement was effectively for $850, rather than $800.
It’s also important to note that since you are likely to have defaulted on your account prior to reaching a debt settlement agreement, information about the default will remain on your major credit reports for seven years from the date that you became 180 days late. Your credit score will suffer during that timeframe.
How Your Creditors Will React:
If you are trying to settle debt that you have already defaulted on and are not making payments towards, then your creditors will continue to contact you as often as they did prior to entering the debt settlement program.
If you start withholding payments from your creditors on debt that you have not already defaulted on, then you should expect:
- Assessment of penalty fees.
- A potential increase to your interest rate.
- Multiple calls and letters from your creditors, trying to convince you to start paying again.
- Your creditors may also file a lawsuit against you, which could lead to wage garnishments if a judgment is entered in the creditor’s favor prior to a settlement being reached with the creditor.
Therefore, it’s important that you do NOT enter a debt settlement program unless you really do not have the resources to pay off your debt OR have already defaulted on the debt and the creditor has not filed a lawsuit against you.
Debt Settlement Pros & Cons
As you can surmise from the above overview, there are both advantages and disadvantages to credit card settlement. For your reference, we will sum up these pros and cons below.