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Debt settlement can be a way to reduce your debt, but it should be viewed as a last-ditch effort to prevent further harm to your finances. It is considered a risky way to negotiate and lower your debt because it damages your credit score, has tax implications, may not solve your problem and more.
Debt settlement can affect your financial well-being in ways that will last for years—perhaps longer than it would have taken to pay off the debt in the first place. Here are six risks of debt settlement.
1. Damage to Your Credit
The nature of debt settlement is to withhold payments to your creditors while you attempt to negotiate a settlement for less than you owe. You may choose to work with a debt settlement company and have someone negotiate on your behalf. A debt settlement company will collect a payment from you and deposit it into a savings account with plans to use the lump sum to eventually settle your debt.
Withholding debt payments has serious consequences to your credit, however. These withheld payments will be reported to the credit bureaus as missed, damaging your credit scores. Payment history is the biggest factor in calculating your credit score, accounting for 35% of your FICO® Score☉ , the score used by 90% of top lenders. Any derogatory mark in this category can have a proportionately damaging effect.
Late payments can stay on your credit report for up to seven years and affect your credit during that entire time.
Another threat to your score is settling for less than the full amount. Debt settlement may only require you to pay 50% to 80% of the full amount you owe. But when you settle for less, your credit score can drop. Your credit report specifically notes if you settle for less than the full amount, and settled accounts are considered a negative entry because it means the lender took a loss.
2. Potential Charge-Offs
The debt settlement process can take up to three to four years. The more time you spend negotiating a settlement amount and withholding payments, the more likely it becomes that your account could be charged off during the process.
A charge-off is when a creditor closes your account because they do not expect you to pay. These stay on your credit report for seven years from the initial delinquency date, or the date of the first missed payment leading up to the account being written off.
3. Increased Costs
On top of financial penalties associated with debt settlement, you may also face increased costs. Debt settlement companies typically charge 15% to 25% of the amount settled. So even though your settlement amount is less than your debt total, you could still owe an extra chunk of change to the debt settlement company.
Debt settlement companies may also charge you fees for administering the savings account used to save up your settlement amount.
4. Tax Implications
When part of your debt is forgiven during the debt settlement process, this forgiven balance is viewed by the IRS as taxable income. You will owe taxes on the portion of the debt that you do not pay as if you had earned that money. For debts of $600 or more, you will receive a 1099-C from your lender.
5. Getting Scammed
While debt settlement companies may be risky in general, some come with a little more risk than you might expect. Some debt settlement companies may be less than reputable, which can leave you with a high bill and few results. Spot a debt settlement scam by looking for:
- Large upfront fees, which legally cannot be collected prior to settlement
- Contact via robocalls
- Promises to remove negative but accurate information from credit reports
6. Debt Settlement Is a Gamble
There's no guarantee that the debt settlement process will work. You could spend months or years missing payments only to have your debt negotiations turned down. At that point, you may be worse off than when you started.
Safer Alternatives to Debt Settlement
These risks can be avoided if you opt for safer alternatives to debt settlement. Some of these options include:
- Debt management plan: Credit counseling agencies are generally nonprofit advisors who can help you get back on track financially either by offering budget advice or, if you are deep in debt, starting a debt management plan. With a debt management plan, the counselor will negotiate a payment plan and lower interest rates so you can pay your debts in full, usually over three to five years. Credit counseling agencies typically charge low fees to set up and maintain a debt management plan, such as an initial setup fee of about $30 to $50 and a monthly fee of about $20 to $75. Look for a nonprofit, certified counselor to seek help with your debt and possibly begin a debt management plan.
- Debt consolidation loan: To save on high-interest credit card bills, you can consider a debt consolidation loan. This is when you take out a loan at a lower rate than what you're paying on your credit cards and use the funds to pay off your cards. You pay back the loan at a lower interest rate and with just one payment instead of many, which saves money and helps with cash flow. However you likely need a good credit score to access a debt consolidation loan, so the sooner you can apply when dealing with debt, the better.
- Balance transfer card: A balance transfer card is a credit card you can transfer existing balances onto. You will pay a transfer fee of 3% to 5%, but often receive a lower interest rate or even an introductory 0% interest rate if you have a qualifying credit score.
- Negotiating debt yourself: You can do all the same—and maybe better—debt negotiation tactics that debt settlement companies can yourself. And better yet, you can do it for free. So if you are set on settling debt without working with a debt settlement company, you may be able to save yourself some fees by negotiating yourself.
Choosing a safer alternative to debt settlement can help protect your credit score and get your debts repaid.
Risk Isn't Always Worth the Reward
When it comes to debt settlement, the risk to your financial well-being may not be worth the reward of reducing the debt you owe. Choosing a safer option like a balance transfer card or working on a debt management plan may work best for you.
Start by getting your free credit report from Experian to pin down your debts and begin your repayment journey.