Is Debt Settlement Necessarily a Bad Thing?

If you have no other options to pay your debt, settlement can be a good thing.

If you have no other options to pay your debt, settlement can be a good thing.

While there can be consequences to debt settlement, it is not always a bad thing, and sometimes it might be your best option. If you are drowning in debt, settlement can relieve your burden and help you get on with your life. Even when debt settlement is a net positive, however, there are long-term consequences. In addition to eliminating your debt, settlement can also stick you with a tax bill and damage your credit report.

Benefits

The main benefit of debt settlement is that you don't have to pay back the full amount of your debt. When done properly, you will have a legal and binding contract preventing your creditor from pursuing you for the full amount of your debt once you pay the agreed-upon settlement value. Some debtors also view settlement as a more ethical option than Chapter 7 bankruptcy, since you at least pay back some of your debt.

Credit Damage

Settling your debt won't do you any favors on your credit report. Although your obligation to pay the rest of your debt is removed after settlement, your credit report will show you settled your accounts, rather than paying them in full. This type of negative account will stay on your report for seven years. Because you probably missed some payments before you decided to settle your debt, your credit is probably already damaged. However, paying your accounts in full, even after late payments, would have a better effect on your credit report than settling your debts.

Taxation

One of the major negatives about settling debt is that forgiven debt is taxable income. For example, if you settle a $10,000 debt for $4,000, you must report that $6,000 of forgiven debt as taxable income to the Internal Revenue Service. If that $4,000 is all the money you have, you are going to have a problem when the IRS comes knocking at your door.

Bankruptcy

Bankruptcy is often thought of as a last resort to eliminate debts. In addition to the social stigma, bankruptcy has the single greatest negative effect on credit scores and can remain on your credit report for up to 10 years. However, debt wiped out in bankruptcy is not taxable. If you have multiple debt accounts, bankruptcy can discharge all of them simultaneously, rather than requiring settlement agreements with each of your creditors.

About the Author

After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.

Photo Credits

  • Hemera Technologies/AbleStock.com/Getty Images