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Debt Settlement is the result of a debt negotiation process that takes place between a creditor and debtor. It is one of several debt reduction options that consumers experiencing mounting debt problems have at their disposal.
We have touched on the topic of debt settlement briefly in our article on Debt Elimination. In this publication, we will explore this option in more depth.
What is Debt Settlement?
In the strictest sense, debt settlement is an agreement between a debtor and a creditor to pay off any remaining debt, at a reduced amount. Settlement occurs when a creditor is satisfied that a debtor no longer has the financial ability to repay the debt owed in full. In agreeing to a debt settlement, the creditor is relieving the debtor from their full debt obligation. Debt settlement is typically the result of debt negotiations.
Qualifying for Debt Settlement
Individuals that qualify for a debt settlement arrangement are those that are experiencing some form of financial hardship that prevents them from being able to fully repay their debts. Often these same individuals have already tried unsuccessfully to meet the terms of a debt management plan, or have previously sought the help of a credit counselor. Debt settlement is a very serious step, and usually one that is taken to avoid declaring bankruptcy.
Typical Debts Eligible for Settlement
Most of the time, debts that are unsecured are good candidates for a debt settlement. That's because unsecured credit, or loans, do not involve collateral, which would allow the creditor to repossess an item of value. Such unsecured credit includes medical expenses, utility bills, and credit card debt. Debt secured by collateral, such as car loans or home mortgages, are not generally eligible for debt settlement discussions.
Debt Settlement Services
The debt settlement process is usually facilitated by a third party service provider. Such providers will usually negotiate on behalf of individuals, and develop a debt settlement plan or program. Such programs allow individuals to lower their monthly payments, and pay off their debts in a relatively short period of time.
Debt Settlement Steps
The debt settlement process usually involves several cycles of steps that are repeated until all creditors are settled in full. The steps in this cycle include:
- Debtor starts saving money into a settlement fund.
- Negotiations take place with creditors to settle the account in full.
- Money is withdrawn from the settlement fund to settle the account.
This series of debt negotiations and payment cycles continues to repeat itself until all debts have been settled or satisfied.
Creditors will Negotiate
Creditors are willing to negotiate only if they believe that payment-in-full will never happen, or the individual is very likely to declare bankruptcy. Only in these situations will the creditor negotiate a partial payment of money owed. This means that the debt negotiator must be equipped with enough facts to persuade a creditor, or lending institution, that debt settlement is the only viable payment option. Typically, creditors will forgive between 10 and 50% of the amount owed.
For example, let's assume you hire a debt settlement company to help you with your credit card debt. You can expect them to negotiate a settlement whereby you still owe the credit card company between 50% and 90% of your outstanding credit card balance.
If you think your settlement is going to be a small fraction of what you owe the credit card company, it is very unlikely that will happen, unless you're faced with an extreme financial hardship. If a company thinks you can pay back more, and they have access to a lot of your credit information, then they are going to make you pay more.
Settlement Documentation
If you are able to negotiate arrangements with a creditor, make sure you have all the payment terms in writing. Don't expect a creditor to remember an arrangement that was made verbally. Make copies of all written correspondence you have with the company, and send letters via registered mail so that you have a receipt showing they received the letter.
When you have a conversation over the telephone, make sure you write down exactly what was discussed, the date of the discussion, and the name of the person that you negotiated with at the company. Follow up all telephone conversations with written letters to the company confirming the settlement arrangements made during negotiations.
Remember, even if you abide by the arrangements, and make all the required payments, this will show up on your credit report as "payment made", not "paid in full." This tells future creditors that not all of the amounts due were paid to the creditor, and will very likely hurt your future credit outlook.
Problems with Debt Settlement
Keep in mind that asking a creditor for debt forgiveness does not come without risks. Generally there are four types of problems that can occur when settling debt with creditors:
- Damage to Credit Rating
- Filing of Lawsuits by Creditors
- Increased Collections Activities
- Income Tax Liabilities
Credit Damage
Since the process of negotiating a debt settlement involves the cycle of saving into a settlement account, negotiations, and then payment of each creditor; this process prevents the debtor from making many of their regularly scheduled minimum payments to creditors. For this reason, an individual's credit rating will likely be hurt as their non-payment of debt begins to show up in the payment history section of their credit reports.
On the other hand, one could argue that this is a temporary, and necessary, outcome of the entire debt settlement process. The sooner the debtor has repaid debts, the sooner they can begin the process of establishing a good payment pattern, and rebuilding their credit scores.
Filing of Lawsuits and Increased Collections Pressure
For the same reason that credit damage can occur, creditors may seek to file lawsuits or increase their collections activities, such as telephone calls, to individuals in the process of entering into debt settlements. By stopping payments to credit card companies and other lenders, the individual is signaling they are in financial distress. Some creditors may take quick action in an attempt to get their money.
Income Taxes and Debt Settlements
If a portion of debt is forgiven through a debt settlement, then debtors may have to report the forgiven debt if it is $600 or more. Creditors will provide debtors with a 1099-C, which will list the exact amount of debt forgiven. IRS Publication 908 explains how to report this information on your federal tax return.
If the taxpayer is deemed to be insolvent at the time the debt was forgiven, then the tax liability is the difference between what the taxpayer has in assets and the amount of debt owed all creditors. For example, if the debtor owed creditors $20,000 and they owned $5,000 in assets, then any amount of debt forgiven in excess of $15,000 must be reported as taxable income on their federal tax return. A taxpayer is considered insolvent when their total debts are in excess of their total assets.
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