Should you settle your debts to become debt free?
Problem:
My wife had a talk with some of the credit card companies we have debt with. While negotiating a settlement, my wife has come to know that the forgiven amount is a taxable income and the settlement once reported to the credit bureaus can decrease our credit score. As far as I know, paying off debts can help increase score instead of decreasing it. Can you suggest whether or not we should go for debt settlement and how it works? I would also like to know whether or not I’ll have to pay tax on the forgiven amount. Is there any option to settle the debts as well as increase my credit score?
Solution:
It is advisable that you take help of debt settlement when your outstanding debt amount is too high and your financial condition doesn’t permit you to pay off the balances in full. Settlement is a debt resolution option by which you negotiate with your creditors to reduce your outstanding debt balance so that it is easier for you to pay off the debts and get your finances back on track. Your outstanding debt balances can get reduced to about 40-60% of what you owe if you’re able to negotiate properly.
You may take professional help if required. However, you’ll have to pay certain fee if you prefer a debt consultant to negotiate with your creditors on your behalf.
The answer to your second question is ‘yes’, you may have to pay tax on the cancelled/forgiven debt amount. The Internal Revenue Service considers cancelled or forgiven debt as income. So, the creditors and the debt collectors accepting at least 600 USD less than the outstanding balance are required to file 1099-C Form (for reporting about cancelled debt) with the IRS along with sending a notice to the debtor. The taxpayers are also required to report the ‘income’ or the forgiven debt amount on their federal tax returns.
Regarding your third query, I would like to say that it is possible to settle debts without hurting your score. This is possible if you can negotiate with your creditors such that the accounts get updated as “Paid in full” after you settle the debts. If your creditors don’t agree, then your accounts would get updated as “Paid as agreed” or “Settled charge-off” that may hurt your score. So, before you settle the debts, get a written agreement from your creditors/debt collectors that they report the accounts to the bureaus as “Paid in full”. It would be favorable for your credit report and help you raise your score to some extent.
After you pay off your outstanding debts through settlement, you should plan a budget and manage your credit responsibly so that you can avoid debt problems in future.
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