You can lower your total debt levels and cut your monthly expenses by settling or paying off your closed credit cards. There are advantages and disadvantages to settling rather than paying off your credit card debt, since both options affect your credit score and your wallet in different ways.
Closing an Account
You can ask your lender to close your credit card account if you no longer want to access funds and instead want to focus on paying off the balance that you owe. Lenders also have the option to close your account if you fall behind on your payments or if you experience a loss of income.
Once closed, your account remains in good standing as long as you continue to make your monthly payments. Continue to make payments until the debt has been repaid in full. If you fall behind on your payments, your lender may agree to a debt settlement, which involves renegotiating the terms of the credit card agreement.
Cost of Payoffs and Settlements
When you pay off a closed credit card account, you pay every penny that you owe your lender. This includes both the principal and the interest owed on the card. When you settle a credit card debt, you pay less than you owe and your lender agrees to write off the rest of your debt.
A lender may agree to a settlement if you simply can't afford to repay the debt. From a lender's point of view, it's better to get some money from you rather than risk getting nothing if you default on the debt. From your perspective, a settlement means saving some cash since you don't have to pay off the entire balance.
Credit Score Changes
Credit card payments, including those on closed accounts, are reported to the three major credit bureaus: Equifax, Experian and TransUnion. Positive payment history, such as paying off a credit card, boosts your credit score. Credit card account settlements are also reported to credit bureaus. The portion of the debt that the lender writes off is listed as an uncollected debt on your credit report. Settlements cause your credit score to drop because lenders don't like to lend money to people who have a history of failing to repay their debts.
Applicable Tax Consequences
When you settle a credit card, the lender effectively pays off a portion of your debt. The Internal Revenue Service regards this partial payoff as a cash gift and you have to pay income tax on this money. Your lender should send you a Form 1099-C, Cancellation of Debt, but you're responsible for reporting the debt settlement even if your lender fails to mail you this form. If you are in the 24 percent income tax bracket, a $10,000 debt write-off increases your tax bill by $2,400. In contrast, a credit card payoff has no impact on your tax liability at all.
Things to Consider
When you settle a credit card debt, you'll find it difficult to obtain credit in the future because a settled account remains on your report for up to seven years. A settlement might make sense, however, if you can't really afford to pay your monthly bill. Late payments incur fees, which add to your debt. Creditors also notify the credit bureaus any time you miss a payment date by more than 30 days. Depending on your payment habits and cash flow, attempting to pay off your card could cause more problems than just settling the debt.