financialcounselor

The Pros and Cons of Debt Settlement

In Uncategorized on March 27, 2012 at 12:41 am

Sometimes, when a creditor is owed money, they are willing to accept less than the full amount of the debt if it is a lump sum payment. Sometimes, the amount they’ll accept is far less than what is owed, and this can seem like a gift from heaven. But this is one gifthorse whose piehole definitely demands a look around. Like with any financial decision, settling a debt for less must be considered in terms of pros and cons, because there are different factors to consider.
First let’s talk about the pros. You save money when you settle up on a debt. That one is obvious. And you’ll have one less stamp to lick each month. So those are the pros.
Now on to the cons, and there are a few. First, realize that settling a debt will hurt your credit score. This surprises a lot of my clients. “But the creditor agreed to the settlement, so why would it hurt my credit?” they ask. Doesn’t matter, even if it’s the creditor who approached you with the settlement offer. The debt will show on your credit report as having been settled for less than the full amount. The reason it hurts a credit score is because potential lenders do not like to see that you did not pay other creditors back in full. It makes them worry that maybe you won’t pay them back in full. And nobody likes getting stiffed. How badly settling a debt hurts your score depends on your particular credit history, but it will be a negative impact. So if you’re planning to take out a loan in the near future, settling a debt probably isn’t a good idea. At least not until you’ve gotten the loan.
Second, and even fewer of my clients are aware of this, there is the tax implication when you settle a debt. Any amount of debt forgiven, if it’s over $600, is considered to be income by our friends at the Internal Revenue Service, and so the forgiven amount is taxed accordingly. The amount forgiven will be reported on IRS form 1099 as income. Here’s an easy way to figure out how much you’re really saving by settling the debt: Just find out what tax bracket you’re in, and subtract it from the amount of debt to be forgiven. For example, if a creditor agrees to forgive $4,000 on a debt you owe, and you fall in the 25 percent income tax bracket, subtract 25 percent from the forgiven amount. In this situation the real savings is only $3,000. ($4,000 minus 25% taxes equals $3,000).
Here’s another thing: if you want to be completely accurate, know where your income falls in your particular income tax bracket. If your normal yearly income is in the upper part of your particular tax bracket, the amount forgiven could push you into the next higher tax bracket. If that happens, however much of this new “income” falls into the higher bracket will be taxed at that higher rate.
Now here’s the final thing to consider when you settle a debt: do you really want to part with all that cash? If settling up is going to take every penny you have, it may not be a good idea to leave yourself high and dry.

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