Over 248 million Americans have credit card debts. And most of them struggle to pay.
According to a study by the National Foundation for Credit Counseling (NFCC), 25% of adults pay their bills late, and 8% have unpaid debts that have gone into collection.
And these figures are expected to rise with the growing student loans, mortgage loans, and auto loans.
If you are one of the many that are caught in the credit debt trap, it may be time to seriously consider debt settlement.
Debt settlement is a repayment strategy where you negotiate with a creditor to pay less than you owe.
If you have a lot of unsecured debts, then a settlement might be the best way to get rid of them in the shortest time possible.
Settling is difficult, however, and it comes with a few drawbacks such as credit score damage and the stress of negotiating with creditors.
To figure out if debt settlement is worth it for you, we have listed four vital questions to ask yourself.
1. Are you in a position to settle?
For a settlement to be successful, you should have a lump sum to offer creditors.
The success rate when debtors have cash on hand to settle is in the 70% range.
Because creditors are more likely to accept an offer when you can pay immediately, besides, the whole point of a settlement is to clear your debt at once rather than continue to make payments for years.
And you can only do that with a full and final lump-sum payment.
If you have a substantial amount to offer (at least 25% of the original balance), then a settlement is worth considering.
Otherwise, put off negotiating a settlement and save. Saving money when you’re in debt may seem counterintuitive, but it’s necessary if you want to make an offer that interests creditors.
2. How much damage will settling do to your credit score?
Your credit score will likely take a hit if you settle. Creditors are not willing to discuss a settlement until you are behind on payments.
So, if you are not already behind, you might have to stop paying for a while to force them to consider settling.
If you have a good score and can keep up with the minimum payments on your cards, try other debt management options before settling.
But if you are behind on payments, your credit score has already taken a hit, and settling can’t do much more damage. Negotiating a settlement is the best option at this point.
3. How much will it cost you to settle?
You save money in a debt settlement program by paying less than what you owe. But settling also comes with other expenses.
If you work with a debt relief company, they will charge a service fee upon successful completion of the settlement.
The fee can range anywhere between 15% to 25% of the enrolled balance. Also, you will pay income taxes on any amount above $600 that your creditor forgives.
So, if you owe $50,000 and the creditor agrees to settle for $20,000, you will pay income taxes on the $30,000 that was waived.
Calculate these costs and make sure you have the provisions to pay. Otherwise, consider a cheaper option like filing for bankruptcy.
4. What are your other options?
Depending on your situation, you can try other debt management options that either lower your payment rate and/or create a long-term financial plan to help you pay.
Debt consolidation and credit counseling are two popular options. In debt consolidation, you take out a new loan to pay your present creditors and continue making monthly payments to the new lender on better terms.
Consolidating simplifies your payment plan and reduces your interest rate, but it increases the timeline on the debt, and you need to have a good credit score to qualify for a new loan.
Credit counseling provides you work with a credit counselor who advises you on debt management and can negotiate with creditors to reduce your monthly payment or interest rate.
Counseling and debt consolidation only work, however, if you can continue to make payments for an extended period.
If you are facing financial hardship, a final settlement may be your only option to eliminate the debt–except bankruptcy.
After answering the questions above, it’s possible you will decide that debt settlement is a good option. In that case, here are the vital do’s and don’ts to be aware of as you begin your settlement journey.
Do’s of Debt Settlement
1. Know your Rights
Before you work with a settlement company, know your rights. A few important things to remember are:
● Never pay an upfront fee to a company who wants to settle your debts. In 2010, the Federal Trade Commission (FTC) banned upfront debt settlement fees. It is illegal for a debt relief company to request a fee before successfully negotiating, settling, or reducing at least one of your debts.
● The same 2010 rule also requires settlement professionals and companies to tell you how their services work, how long the settlement will take, and what it will cost before you sign up.
● The debt settlement company may help you open an account where you deposit money to save up for a lump-sum payment. This shared account must be at an FDIC-insured financial institution that has zero affiliation with the settlement company.
● In the same vein, the settlement company has no control over the money in the account. You own all the funds and the interests the account incurs, and you can withdraw your money without penalty.
Avoid any company or settlement professional that doesn’t apply these rules especially if they ask for an upfront fee.
2. Get Organized
Creditors require proof of financial hardship before considering a settlement. You should have documents showing your income, assets, and liabilities. Organize these documents before approaching your creditor to help the process move along quicker.
3. Document Everything
Keep documented evidence of your settlement deal. Creditors often sell delinquent accounts in bulk to debt buyers, and may sometimes include accounts of individuals who have settled or even paid their debts.
You can suddenly start to receive collection calls from debt buyers years after a settlement. And the only way to protect yourself is by showing official documents of your settlement deal.
Most banks and collection agencies use a templated letter as the settlement agreement. You need to have a copy of this letter.
Read the fine print of your settlement letter carefully. Check that you are identified correctly in the contract and your account name as well.
The specific dollar amount you pay and any payment terms also have to be in the document.
The contract should also acknowledge in words that you are settling the debt not paying it down. In addition, keep your bank statements and checks as proof of payment.
4. Make Sure the Account is Settled
Your credit report is updated after a debt settlement to reflect the settled account and a zero balance. Check your report a month or two after to ensure it reflects the settlement.
Creditors are required to report a settlement to credit bureaus, but they sometimes don’t, and the account can remain delinquent on your credit report.
In this situation, you can dispute the status of the account by sending documents of the settlement to the credit bureau.
5. Prepare for the Tax Consequences
Unfortunately, the IRS requires you to pay an income tax on every dollar your creditor forgives. Creditors report any debt they forgive (above $600) to the IRS using a 1099-C “Cancellation of Debt” tax form.
You will receive this form in your mail and should include the canceled amount in your gross income.
The tax bill can sometimes be hefty, so consult with a tax advisor to know the tax consequence of a settlement before you agree to a deal.
If you can prove you are insolvent at the time of a settlement, you may be exempt from paying taxes.
Insolvency means you have more debts than assets. To find out if you were insolvent, add up your assets and debts including the debt you settled.
If your debts exceed the value of your assets, include Form 982 with your tax return, and the IRS may reduce your tax bill.
Don’ts of Debt Settlement
1. Make a false commitment
Don’t agree to a settlement amount you can’t pay, especially if you are paying in installments.
If you promise too much and end up defaulting after the first few payments, you will lose money and force the creditor to intensify their collection efforts.
Most creditors eventually have to settle for pennies on the dollar for unsecured debts, so don’t be afraid to start negotiations low and aim to pay fifty percent or less of the original balance.
2. Drain your savings
Don’t exhaust your savings on a settlement. Debt settlements are not always successful, and you could end up losing a lot of assets only to find yourself still in the hole.
Two savings you shouldn’t touch are your emergency fund and 401(K). You should have at least $1000 saved up for emergencies or the equivalent of a month’s expense.
Without this cushion, you may turn to credit cards (and incur more debt) if you suddenly lose a job or your car breaks down. As for your 401(K), dipping into a retirement account early will come with a hefty tax penalty.
Usually, the penalty is 10% of the amount you withdraw besides Federal income tax. If you can’t pay the settlement amount without dipping into your 401(K) or emergency funds, then consider another payment option.
3. Don’t Delay Settling
Don‘t wait until your account is charged off before trying to settle. Usually, this happens when you miss payments for about six months.
The creditor writes off the account as a loss but you are still responsible for paying the debt, and the late payments will remain on your credit report for seven years.
Your credit score will be damaged if it hasn’t already, and creditors may sell your account to collection agencies who can make life miserable.
It’s best to be proactive about your debt. Reach out to the credit card company or bank quickly if you are facing financial hardship. Creditors are loss averse and would rather settle than write off a debt.
Before you commit to a settlement, consider your financial situation, the tax implications, and the damage to your credit score.
Also, know your rights when dealing with creditors and debt settlement companies.
Finally, keep your settlement letter, bank statements, and checks as evidence of the agreement.