Debt settlement is often given a bad rep and much of it has to do with the massive amount of wrong information floating around.
The reality, however, is debt settlement is a great repayment strategy that comes with many benefits.
Settling is quicker than many other payment methods, it does less damage to your credit score than bankruptcy or simply ignoring creditors, and you get to make a partial payment as full satisfaction for the debt.
Common Misconceptions About Debt Settlement
To successfully settle your credit card debt, however, you must know the facts from the myths. As a start, we have debunked ten myths about settling credit card debt.
Myth No. 1: Anyone can qualify for debt settlement
Fact: Credit card companies are under no obligation to settle and mostly do so when a debt has become delinquent with little chance of you paying it back in full.
You must prove a certain level of hardship such as job loss, divorce, or illness to qualify. The same goes for legitimate debt settlement companies.
A good company screens and evaluates you to make sure you meet the conditions for debt relief before offering you a settlement plan.
Another common misconception closely related to this one is that you can settle any amount of debt.
Most creditors will refuse to settle a debt below $7,500.
The reason is at a lower amount, settling the debt makes it worthless to the creditor.
If you do not have a substantial amount of debt to settle, credit card companies won’t agree to a negotiation.
Myth No. 2: You can easily handle a debt settlement by yourself
Fact: While you can negotiate a debt settlement by yourself, the process isn’t as easy as the internet would want you to believe.
You must be a shrewd negotiator to convince credit card companies to settle.
You must also be patient because the process is long and tedious.
If you have the time and financial knowledge, then negotiating yourself will save you money.
But if you don’t, it’s best to hire a debt settlement company.
Debt settlement companies have expert negotiators with inside knowledge.
They often know how much a credit card company will settle for, which saves you a lot of time haggling.
Settlement companies also have a leverage with creditors due to the large volume of business they bring.
Myth No. 3: You have to pay upfront to settle your debt
Fact: In 2010, the Federal Trade Commission (FTC) ban settlement companies from collecting advance fees before settling debts.
No legitimate debt settlement company will ask you to pay upfront for their services.
What you are expected to pay is an agreed monthly amount to save up a lump-sum for settling creditors.
You make your payments into a bank or savings institution and the money belongs to you along with any interest charges.
The debt settlement company does not own or control this money.
In addition, settlement companies must tell you specifically how much the process will cost beforehand and the risks you will face.
Myth No 4: Debt settlement will damage your credit score.
Fact: Yes, debt settlement will affect your credit score but not to the point of damage.
How badly your score is affected depends on the size of your debt, how much is removed from the original amount, how quickly you can come up with the lump-sum payment, and your score before starting the process.
If your score is less than perfect–which is usually the case–then settling will have little impact.
A settlement plan allows you to pay less than the original debt and this is a breach to your credit agreement–which requires you to pay in full.
As a result, your credit score takes a hit, but not as much as it would take if you continue to pile up the debt.
Besides, the reduced financial burden is worth the drop in your credit score.
You can focus on rebuilding your credit once you are debt-free.
Myth No. 5: Credit reports reflect unpaid balance on the settled debt
Fact: When you successfully settle a credit card debt, the creditor updates the account to settle, and the balance becomes zero.
Your credit report will reflect this–depending on when the creditor reports your settlement–but will not show the unpaid or forgiven balance.
The settled account, however, will remain on your credit report for seven years.
If you settle a debt that has no history of late payments a.k.a. delinquencies, the settled account remains on your credit report for seven years from the day the creditor reports it settled.
But if you already have a history of late payments–which also remain on your credit report for seven years–settling will not reset or add any extra time.
After you settle, the settled account will remain on your report for seven years starting from the date you made the first late payment.
Myth No. 6: You can settle for pennies on the dollar
Fact: Easy settlements for pennies on the dollar are rare unless you are settling a much older account.
Credit card companies do not want to lose money and will mostly refuse to settle newer accounts for so little.
A more realistic amount is 30 to 40 cents on the dollar.
The only exception is if you can prove true hardship.
Expect little cooperation from a creditor if you have a steady source of income or equities such as a home or a car.
Myth No. 7:Settling is your only option to get out of credit card debt
Fact: Debt settlement is not your only option.
If you find yourself deep in debt due to financial hardship, write a hardship letter to your creditor requesting assistance.
The letter should give a detailed description of your current financial situation, the cause of your hardships, and the help you want.
Usually, creditors will give you an alternative payment option, reduce your monthly payments, or reduce your interest rate.
Sometimes, creditors can waive late fees and penalties.
You can also seek the help of a credit counselor.
Credit counseling can help you eliminate or reduce your debt by educating you and providing tools you can use to budget.
Credit counseling agencies also have the power to negotiate with creditors on your behalf.
But they can only negotiate to lower your monthly payments, not to reduce the total debt.
Settling is the only way–except bankruptcy–to eliminate credit card debt.
Myth No. 8: Debt settlement relieves you from all debt
Fact: After you settle, you have to pay taxes on the forgiven debt to the IRS.
The law requires creditors that agree to collect at least $600 less than the original credit card balance to file 1099-C forms with the IRS and give you a notice.
You are meant to report the forgiven debt as income on your tax return.
So if you had a credit card debt of $10,000 and settled for $6,000, you are required to report the forgiven $4,000 as income and pay taxes on it.
What happens when you fail to do so is the IRS sends you a “Cancellation of Debt” tax notice usually months after the settlement and this puts you at risk for audits, penalties, and fines.
If you can prove to the IRS that you were financially insolvent–meaning you had more liabilities than assets–at the time of the settlement, you may qualify for a tax exemption.
But the exemption only applies to the amount by which you were insolvent.
So using our earlier example, if $4,000 is forgiven, and your liabilities exceed assets by $1,500, then the $1,500 will not be counted as taxable income.
The remaining $2,500, however, will be counted and you will have to pay taxes on it.
Talk to a tax preparer or advisor when you get 1099-C cancellation of debt forms from your creditor.
Myth No. 9: Debt settlement is the same as Debt consolidation
Fact: Debt settlement and debt consolidation both help you reduce the financial burden of your debts but in different ways.
Debt consolidation requires you to take a consolidation loan, which is a single loan that combines all your previous debt into one so you have a single creditor with one monthly payment and one interest rate.
If you have multiple debts with different lenders, it can be stressful handling them all.
Merging will give you a simple payment strategy and can even lower your monthly payment or interest rate.
You can get a consolidation loan from a financial institution but you need to secure the loan with an asset such as a house, car, insurance policy, or your retirement account.
Debt consolidation will extend the length of the loan, which for many is a disadvantage.
Putting up a collateral is also risky, and you shouldn’t unless you are confident in your ability to pay back the debt.
Debt settlement will not combine your loans into one.
If you have multiple credit card debts, you will have to negotiate with each creditor for a settlement.
Debt settlement also aims to shorten the term of a loan by making a lump sum payment to creditors that clears you of all financial obligations.
Finally, you don’t have to put up an asset as collateral in a debt settlement.
Myth 10: All Debt Settlement Firms Are The Same
Fact: Not all debt settlement companies are the same.
Unfortunately, the legitimate ones are largely overshadowed by scams and firms with poor practices. Avoid any company that:
- Asks you to pay upfront before negotiating with creditors successfully
- Talks about a “new” program that will fast-track debt settlement
- Asks you not to communicate with creditors without giving a reason or explaining the consequences
- Asks you for personal financial information before explaining their services
- Is not registered with the state
- Guarantees it can settle your debts fast and easy
What you should look for is a company that:
- Fully discloses all costs and fees before you sign up.
- Provides you with written policies on their debt settlement process
- Provides an estimate of how much a credit card company will settle for and the amount you should save before negotiations begin.
- Tells you specifically how long it will take to negotiate with creditors.
- Sends every resolution offer to you before presenting them to creditors.
Do your Research
You should do thorough research before settling your credit card debt especially if you decide to work with a debt settlement company.
Choosing the right people to help you with your debt will save you time, effort and money.
Lastly, make sure settlement is a viable option for you.
So what other myths about settling credit cards have you seen? Just leave a comment below with some of the myths you have seen.
Schedule a free consultation today for a risk-free debt assessment. The only thing you have to lose is your debt.