What You Should Know Before Settling Credit Card Debt

What You Should Know Before Settling Credit Card Debt

If you’re up to your eyeballs in debt and can’t see the light at the end of the tunnel, you might be considering the services of a debt settlement company. You’re not alone; the recession has caused many to seek this option. While it’s not recommended, debt settlement has become a quick fix for consumers in a bind. But before you settle your debt, know the risks involved.

Understand what you’re getting into. Debt settlement is when your lender agrees to settle for less than the full amount due. A debt settlement company acts as a middleman to help you get out of a debt you can no longer pay. (However, you can also settle a debt on your own.) “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, author of Reduce Debt, Reduce Stress, and a financial expert at Credit.com, a credit education Website.  Detweiler notes that in cases where a debt is settled improperly there’s a risk that a creditor might sue to get their money.

Be aware of fees. Debt settlement companies can charge anywhere from 5% to 25% of your total debt, which is often broken down into payments. “Some payments are upfront and some are on the back end,” says Detweiler. However, you could be asked to pay as much as three upfront monthly of fees to the settlement company. Meanwhile, they’ll tell you to stop paying your credit cards. “They really have to. The truth is, I haven’t seen any credit card company willing to settle with a consumer who is current on their bills,” says Detweiler. “Debt settlement is a last resort for someone who is in trouble and wants to stay out of bankruptcy.”

Your credit will take a hit. Settling your debt might provide some relief, but it will negatively impact your credit. “The impact of debt settlement on your credit score is severe. First, you’re going to fall behind on your bills, 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,” says Detweiler.

The tax man will come a knockin’. Once your debt is forgiven, you won’t be riding off into the sunset without a care in the world. The forgiven portion is considered taxable income, and must be reported to the Internal Revenue Service. You’ll receive a form from your lender called form 1099-C, cancellation of debt. If you had at least $600 forgiven, the lender or debt collector is required to file with the IRS.

Get it in writing. Make sure you get a letter from your lender stating that you settled your debt for a certain amount. “Otherwise, you could authorize the debt settlement company to take payments, and then before you know it, your lender is coming after you for the balance,” says Detweiler.

In part two of this post, we’ll share 10 questions to ask a debt settlement company.

Sheiresa Ngo is the consumer affairs editor at Black Enterprise.