Many debt settlement companies are now required by federal law to tell you about any consequences of debt settlement before they sign you up for their services. Also, this new federal rule likely applies to all settlement companies who pitch their services to you by phone. Other companies should tell you for the sake of disclosure, but the federal law doesn’t require them to, so they may not.
Even if you settle debts on your own, there are certain drawbacks that you should know about before you go into the process. These drawbacks don’t necessarily have to change your mind about settlement, but it’s better that you aren’t surprised by what may come.
Settlement isn’t guaranteed.
Debt settlement is just a negotiation process. While many creditors and debt collectors do settle debts for less than what you owe, not all of your creditors will agree to settlement. Settlement is more likely when you’re far behind on your debts or when they’re outside the applicable statute of limitations. But, other debts you may have to pay in full.
Settlement doesn’t erase negative history.
When you settle your debts, it doesn’t remove them from your credit report. As long as these accounts are within the credit reporting time limit, which is seven years for most delinquencies, they will continue to be listed on your credit report. Any previous missed or late payments and charge-off accounts will likely stay on your credit report. You may think about paying these debts in full if you can get the applicable creditor to remove your debt from your credit report completely.
Account’s status will report “settled.”
Once you pay off your settlement, the creditor or debt collector will typically update your credit report to show that the debt is $0 and add a comment to show that it’s been settled. The settlement status will then show up on your credit report for seven years. This status will likely negatively affect your credit score in the short-term, but as the account ages and you add more positive information to your credit report, the impact should lessen.
Settlement takes time.
If you’re already behind on your credit card bills, you have a better chance at settling than if you were current on all your payments since creditors don’t usually settle debts that aren’t delinquent. Even after you fall behind, you usually need to have enough cash on hand to pay the settlements. That could mean saving up some money for a few months before you negotiate a settlement. In the meantime, you’ll likely have to dodge calls from creditors and debt collectors.
You could owe taxes on cancelled debts.
The IRS wants you to pay taxes on any debt that’s cancelled that is $600 or more. So, for example, if you pay a $400 settlement on a $1,000 debt, you’ll probably get a Form 1099-C from the creditor or debt collector around tax time. A copy of this form is also then sent to the IRS, so your tax return may be rejected if you leave off the settled debt amount. Cancelled debts could reduce your tax refund, if you’re due one, or it could increase the amount you owe.