What You Should Know Before Settling Credit Card Debt

Be aware of risks before hiring a company to handle negotiations

Many consumers have come to see debt settlement as a quick fix when they’re in a bind. A settlement will stain your credit history, and should be your last resort to avoid debt collectors. Black Enterprise recommends negotiating on your own, but if you absolutely must hire someone else to do it, you should know the risks involved. Federal Trade Commission rules that went into effect in September and October require third-party debt settlement companies to disclose these risks before consumers consent to hire their services.

Understand what you’re getting into.
Debt settlement is an agreement a creditor makes to settle for less than the full amount due. The settlement company acts as a middleman to help you get out of a debt you can no longer pay. “Debt settlement companies help consumers negotiate their debts so they can pay them off for less than they owe and avoid bankruptcy,” says Gerri Detweiler, a personal finance expert at Credit.com, a credit education website. However, this arrangement results in a negative mark on your credit report. Detweiler also notes that there’s a chance that a creditor could sue to get full payment, a disclosure that settlement companies now must make when debtors seek their services.

Know the effect the arrangement will have on your credit score.
These companies have to tell you that debt settlement will hurt your score; it could drop by as much as 150 points. The settled debt will stay on your report for about seven years. “The impact of debt settlement on your credit score is severe,” Detweiler says. “First of all, you’re going to fall behind on your bills [because many companies tell debtors to stop paying], and second, when you do settle your debt it’s typically reported to the credit reporting agencies as settled for less than the full balance or it may reach the status of charge off, which is where it’s written off the creditors’ books as a bad debt.

Be aware of the tax implications.

Depending on the type of debt, the forgiven portion is considered taxable income and must be reported to the Internal Revenue Service. Settlement companies aren’t required to tell you this, but the FTC advises that they do. If you had at least $600 forgiven, the lender or debt collector is required to file with the IRS. However, mortgage debt and debts discharged during bankruptcy might be excluded from being taxed as income. Note, however, that you might have different tax obligations on the state level depending on where you live.

Prepare for fees.
Until recently, some debt management companies charged high up-front fees before they did any work. New FTC rules ban fees until firms perform services. Keep in mind, they’ll tell you to stop paying your credit cards. If you stop paying your bills, this may result in new fees and interest from the credit card company. Under the new rules, a debtor must be given an estimate of fees based on his or her specific situation and the company’s experience with the potential client’s creditor.

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  • vickie

    FYI collection companies are buying staledated accounts. They are calling the individuals relatives and saying they r the IRS, and giving out personal information about filing a 1099 C. I have reported them to FTC and they are still calling several times a day.