Editor's note: This article originally ran on WisePiggy.com. It has been reprinted here with permission.
It can be tempting to settle past debt amounts with collectors, but it's not a decision that should be made lightly. A debt settlement can affect your taxes, and it can actually have a negative impact on your credit score. Before you come to an agreement with a debt collector, there are a handful of considerations you should know about.
Debt settlement, consolidation and management: what's the difference?
First, you should know the difference between three types of debt strategies: settlement, consolidation and management.
"Debt settlement is where a consumer settles a debt for less than the full balance owed to resolve the debt — a partial repayment," explains Thomas Nitzsche, a spokesman for ClearPoint Credit Counseling Solutions. "This is done via a lump sum payment to the creditor, and the debt usually has to be in severe default."
Nitzsche adds that for-profit debt settlement companies will promise to "settle for pennies on the dollar," then hold payments from the consumer and attempt to settle their defaulted debt in the future.
Debt consolidation involves taking out a larger loan to pay for smaller loans. The goal here is a lower interest rate, but many times it means stretching out the life of your debt and paying more in the long run. And then there's debt management. Professional debt management is often done through a nonprofit credit counseling agency.
"(This) allows the consumer to receive lower interest rates, waived fees, and a fixed and often lower total monthly payment on multiple creditors (usually credit cards)," Nitzsche says. "The payment is made through the credit counseling agency and is disbursed monthly to the creditors. This is a full repayment of the debt and lasts a maximum of five years."
The differences between the three are relatively simple, but they're important to understand, nonetheless.
Pros and cons of debt settlement
Let's look into the advantages and drawbacks of debt settlement in a little more detail.
There's an obvious advantage to debt settlement: paying a much smaller amount than you owe. Sometimes this amount is less than half of your original debt. The hope is that your past debt disappears and you no longer have to worry about it. It's a tempting thought.
But you should also know the disadvantages to debt settlement — and there are plenty of them.
According to the Federal Trade Commission, there's a chance that your creditors won't even accept the settlement.
"Creditors are under no obligation to accept a settlement, so there is no guarantee that they will accept less than what is owed, even when in default or when employing a debt settlement company," Nitzsche elaborates. "The creditor can sue the consumer at any time when the debt is in severe default, so there is no guarantee that the debt will be settled before they take this action."
Leslie Tayne, a financial attorney and debt specialist, says this isn't uncommon. Sometimes, the company fails to obtain proper paperwork, and the debt remains unpaid.
"This happens often," Tayne says. "Especially when people try to do it themselves they don't understand what is needed to close the account."
Settling a debt can have a negative impact on your credit. It requires severe default, Nitzsche explains, and you can expect a big hit to your report and score. That information will stay on your report for seven years. If you haven't done so already, check your free credit score and your credit report.
The FTC says these programs often encourage you to stop sending payments to your creditors. This can not only lead to a lower score, as Nitzsche points out, it can also lead to creditor late fees, penalties, and even wage garnishment.
Taxes are also an important consideration when it comes to settling debt. You may actually owe taxes on the amount of debt that's forgiven.
"Consumers typically receive a 1099 tax form when they settle more than $600 in debt, thus making the amount forgiven taxable," Nitzsche explains.
Fees are another consequence of debt settlement — many settlement companies will charge you for their services, and these fees are often significant. Legal site NOLO.com explains that, in addition to upfront fees and contingency fees, many of these debt settlement companies pull you into a long-term plan that involves you depositing regular payments into a bank account before they actually settle your debts. These accounts may have high maintenance fees. That's enough of a drawback, but missing a payment could be an even bigger concern.
"If the debtor misses a payment under the program, the plan may terminate, reinstating all of the original balances due to each creditor plus the contractual interest that has accrued," Robert Semrad of DebtStoppers, a bankruptcy law firm, explains.
NOLO says there are an increasing number of illegitimate debt settlement companies, too.
Here are some signs you may be dealing with a debt settlement scam:
- They guarantee to settle all of your debts for "pennies on the dollar."
- They advertise a "new government program" to eliminate personal credit card debt.
- They tell you to stop communicating with your creditors, but don't explain the consequences.
- They claim they can stop all debt collection calls and lawsuits.
- They charge high upfront fees before any debts are settled.
How to settle your debt cautiously
If you're working with a debt settlement company you believe is legitimate, you should still proceed with caution. Research the company's history with the Better Business Bureau, and see how many complaints have been filed. Obviously, you want to look out for lawsuits, and make sure the company hasn't been reported to any government agencies.
"There is never a guarantee as to what a creditor will do," Tayne says. "Work with professionals who have been in the business for more than a year or two who do only this. Reputation is key."
Of course it's also important to regularly check and know where your credit stands, before and after a debt settlement. You should understand the tax implications and be aware that your credit report will be marked as "settled" rather than "paid in full."
Most experts recommend looking for additional options before turning to settlement. Nitzsche suggests only pursuing a settlement if the actual creditor says an "account rehabilitation" isn't possible. Account rehabilitation involves coming to an agreement with the original creditor, who will pull your debt out of collections and put you on a payment plan to rebuild your credit.
"The consumer should set aside money into savings and beginning when they have approximately 30 percent saved, they should contact the collector to discuss settlement," he says. "Bank account information should never be given to a collection agency and the consumer should request the settlement agreement in writing and send payment via certified mail or Western Union 'Quick Collect' for proof."
Semrad says, in some cases, bankruptcy may be better than debt settlement.
"If, alternatively, the debtor does not believe he/she has the financial wherewithal to get out of debt by themselves, they should seek free professional advice," Semrad says. "In many instances, bankruptcy is a much better option than a debt settlement program. While the filing of the bankruptcy causes an initial hit to a person's credit, it immediately stops all future negative reporting to the credit bureaus."
Experts offer one final word of caution: if you do decide to go the settlement route, keep records of everything. Make sure you have documentation of all correspondence and payments.
Kristin Wong is a freelance blogger who frequently writes about relationships for MSN’s The Heart Beat blog. After paying off her student loan debt, Kristin decided it was time to pursue her dream and also put her English degree to use.