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Do debt settlement programs really pay off?

With all things financial, you have to read

With all things financial, you have to read the fine print. That's certainly the case with debt settlement.  Credit: Getty Images / fStop / Epoxydude

You’ve been struggling for months to pay your credit card bills. Maybe you’re frequently late or have missed payments. That hefty outstanding balance is like a noose around your neck.

Much to your surprise, one day you get a letter from your creditor offering you the chance to settle your debt for less than you owe, and likely, much less, perhaps 30-70%. Is it a gift from above?

Before you jump at the opportunity, here’s what to consider.

The pros

No doubt, settling for less than you owe has much appeal. There are other pluses. “Settling your debt can also help you avoid filing for bankruptcy and help free up cash flow in a way, since your monthly payment will typically be less than what you might have been paying out,” points out Leslie Tayne, a debt resolution attorney with the Tayne Law Group in Melville.

Since payment history is the biggest contributing factor to your credit score, being delinquent on payments will inherently hurt your credit score. However, once you begin the debt settlement process and your debts are being paid off, your credit score will begin to rise because your credit utilization will be decreasing. Also, having a debt listed as “settled” on you credit report hurts your score less than having a delinquent account, explains Tayne.  

“I’ve had many clients tell me their score has risen to over 700" even before they've finished paying off the new debt amount, she says.

A credit score above 670 is considered “good," between 580 and 669 is considered “fair” and below 580 is considered poor, Tayne said.

Then there’s no discounting the relief of getting the debt monkey off your back. Paying off even a portion can "give you a sense of mental satisfaction. People have shared how settling a debt improved sleep and enriched personal relationships with a spouse and improved their overall quality of life,” says Daniel Hill, president of D.R. Hill Wealth Strategies in Richmond, Virginia.

The cons

With all things financial, you have to read the fine print. That’s certainly the case with debt settlement. Know what you’re getting into. Understand that there are tax implications. “The portion of your debt not paid back is counted as taxable income and you will have to pay taxes on that amount. It’s easy to gloss over this fact in the moment, but if it’s a large sum, you may owe substantial federal and state income tax. This could put you in a further financial bind if not given careful consideration in advance,” says Amal Gawle, president of NOVA Capital Advisors in Melville.

You must include the debt cancellation as income on your taxes. The creditor will send you Form 1099-C and a copy to the IRS. So, if the company agreed to settle a $10,000 debt for $2,000 you would pay tax on $8,000.

“Let's say you're in the 22% tax bracket, the extra $8,000 of income is roughly $1,760 in tax. It's still not a bad deal to settle a $10,000 debt,” says Thomas Williams, a tax accountant and author of "Deducting the Right Way."

Gone, but not completely forgotten.  A settled debt can remain on your credit report for seven years, says Hill. However, future creditors will see that you took the initiative to settle the debt. “You can always explain to the new creditor what was happening during this time of your life: you lost a job, went through a divorce, etc. At this point, the creditor may consider that time of your life as unusual or atypical and grant the credit you are currently seeking.”

Mistakes to avoid

If you decide to take a debt settlement offer, be sure you get an offer of the settlement in writing before you send any money, advises Grayson Stalvey of Grayson Stalvey Financial Coaching in Cincinnati.

Don’t be blinded by zeal to say adios to your debt, he said. “Make sure you can pay as required by the settlement. If you agree to a lump sum or monthly payment that you can’t afford, you’ll quickly find yourself back in the same predicament.”

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