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Are you considering debt settlement? Have you been tempted by the commercials featuring the man with the sad, sympathetic voice who asks, “Do you owe more than $10,000 in credit card debt?”
I know I’ve been tempted in the past to call one of these companies. After all, if I could have $10,000 in debt reduced to $5,000, that’s just free money in my pocket that I could invest in my business, save, or use to fix up my home. Right? Not really.
Debt settlement is a good last resort for mounting credit card debt, when you can’t see the light at the end of the tunnel and your only other option is bankruptcy. But it’s not money in the bank, an easy solution to your money problems, or a decision you should take lightly.
Why not? Here are three compelling reasons.
Debt Forgiveness May Count as Taxable Income
If you are in debt (with more than $10,000 credit card debt, according to most guidelines) you are eligible to negotiate with your creditors through a debt settlement company.
The debt settlement company may settle your debts for as little as 50 cents on the dollar. But that “forgiven debt” is usually taxable income, and often taxed at the highest possible rate.
If you’re already in debt, the last thing you want is to owe the IRS money, as well.
Debt Settlement Hurts Your FICO Credit Score — Badly
When a debt settlement company negotiates for you, first the company must wait until you are 90 days in default. Timely payments count for approximately 35% of your FICO credit score.
According to the credit score simulator at CreditSesame, if I were to let just one of my credit card accounts go into default by 90 days, my credit score would drop 50 points. (Keep in mind, results vary based on your current credit score and many other factors.)
And the damage to your credit score doesn’t end there. Once the debt settlement company has negotiated payments for you, the company may hold your payments for the first several months as their fee. Meanwhile, your credit score is continuing to drop like a stone.
Finally, once a settlement is negotiated, your debts will be listed as “settled,” rather than “paid in full.” This black mark stays on your credit report for 7 years, and is a big red flag (on some reports, quite literally, as the bad news is printed in red!) to lenders that you may not be able to manage credit responsibly.
Another alternative, bankruptcy, will also drop your credit score to the low 500s and a bankruptcy stays on your credit report for 10 years.
If you intend to secure new credit, buy a house, buy a car, or even find a new apartment or a job in the next 7 to 10 years, it’s best to avoid both of these options and simply negotiate payment plans with your creditors individually.
You Can Handle Debt Settlement Yourself
Debt settlement companies are for-profit businesses, which means they have to make money somewhere. They make that money from the fees they charge you. You may be paying only 50% of your debt, but you’ll also have debt settlement fees added to that total.
With a bit of patience and some negotiation skills, you can negotiate debt settlement yourself. When you do so, you want to focus on several things — not just the overall money you will pay to your creditor.
Other factors to consider when you negotiate debt settlement include:
- The overall interest rate
- How the debt settlement will be listed on your credit report. Ideally, you should negotiate an arrangement for a lower interest rate and be able to pay your debt in full over time, where it will be listed on your credit report as “paid in full.”
- Your payment plan, including manageable monthly payments
- Keeping the account open, rather than having the creditor close the account
If you are struggling with debt and bankruptcy is your only other option, debt settlement may seem appealing. But it’s best to speak with a not-for-profit credit counselor, first, and to understand the facts behind debt settlement and its affect on your credit score and your financial life.