If you have a pile of credit card debt and some settlement outfit offers to fix it for you, be careful. You could wind up damaging your credit score and owing a bunch of tax. It depends on how those debts are resolved and how the resolution is reported to the credit bureaus and the Internal Revenue Service. Make sure you know that before you agree to settle any debt.
While paying in full means you paid your debt as you agreed to, a settlement means you ended up paying less than you owed, and it can have negative tax and credit implications.
Payment in Full Eliminates Debt
Payment in full is always the best way to eliminate a debt. It means you have completed your obligation; you borrowed $5,000, you agreed to pay it back, and you did. This wipes the debt from your credit report and improves your score two ways – by reducing total debt and indicating good payment history. Those elements make up 65 percent of the score.
Settlement Can Hurt Your Credit
A settlement for less than you owe can hurt your credit score if it is reported as "settled" and not "paid in full." A settled debt indicates that you didn't complete your obligation. It remains on your credit report for up to seven years, and depending on the amount involved, can lower your credit score – the rating lenders use when deciding whether to issue a credit card or let you buy something on installments. How much it affects your score varies with the amount of debt forgiven.
Tax Implications for Settlements
You also can wind up with a tax bill if you settle for less than you owe. The IRS considers any difference between what you owed and what you settled as income. If you had a $5,000 credit card debt and settled it for $3,000, the IRS counts the other $2,000 as income. You and the IRS will both get a 1099-C showing that as income.
Work With Your Lender
You can avoid problems with a settlement payment by getting the lender to agree to report it as "paid" rather than "settled." If you agree to pay $3,000 to settle that $5,000 debt, write on your check "Endorsement of the check constitutes a complete settlement of your claim." If the lender cashes that check, a court will likely hold that it's agreeing that you paid off the debt and you can't be required to pay that other $2,000. It also should be reported to the credit bureau as paid in full.
- Experian: Can You Negotiate a Settlement for Credit Card Debt?
- Experian: Is it Better to Pay Off Bad Debt or Settle it?
- Consumer Financial Protection Bureau: What Is the Best Way to Negotiate a Settlement With a Debt Collector
- Oak View Law Group: Credit Card Debt Settlement - Settle Online and Save Now
- Cornell Law School: Uniform Commercial Code: Accord and Satisfaction
- FICO: What's in My FICO Scores?