What You Need to Know About Settling a Credit Card Debt

6 Credit Cards That Can Help Get Your Debt Under Control

People in credit card debt have several options for getting out of it, but none of them are simple. For example, using a loan to consolidate debt at a lower interest rate requires you to have good enough credit for a personal loan. If you want to tackle it the old-fashioned way (paying off as much debt as you can, as fast as you can), you may need to make extreme changes to your budget or significantly increase your earnings.

You could also look into settling your credit card debt for less than you owe, but there are a lot of consequences consumers need to consider before choosing this option.

How It Works

If you can’t make your minimum payment on your credit card, but don’t want to declare bankruptcy, settling the debt for less than you owe might be a good option for getting out of debt. You can either negotiate the settlement with your original creditor or pay a debt settlement company to do it for you, but either way, things are likely to get worse before they get better.

“The account in some cases would need to fall at least 60 days past due before a creditor would consider a settlement,” Christopher Viale, president and CEO of Cambridge Credit Counseling in Agawam, Massachusetts, said. That means your credit score would suffer from the negative payment history. (If this happens to you, read our guide on how to improve your credit score.)

Viale said most creditors will offer a settlement for 50 to 70 cents on the dollar of what you owe. Even though you won’t pay the full amount of your debt, you’ll need to settle it in a lump sum, which can be a lot of money.

Some creditors might offer a payment structure, but it might be a short term (with high payments) and will probably not be as discounted as the lump-sum settlement, Viale said. If you enter a debt settlement program with a for-profit company, you will likely make payments into a special savings account for several months until you have enough for a lump-sum settlement. But, in the meantime, your debts will be delinquent or in default.

“I think the most important part is understanding how the settlements work in the first place,” Thomas Nitzsche of ClearPoint Credit Counseling said. He said ClearPoint encounters a lot of consumers who start working with debt settlement companies without understanding that their payments won’t go to their creditor until they have enough for the lump sum and are surprised when they start getting calls from debt collectors or see their credit scores suffer.

Things to Keep in Mind

When negotiating the settlement, make sure you get the agreement in writing before making the payment and written confirmation once the debt has been settled. It’s not unheard of for people to receive debt collection notices on a previously settled debt and, if this does happen, you want to have proof to challenge it. (Check out these 14 questions you should ask a debt settlement company before signing any agreements.)

“If it gets sold somewhere else and if you don’t have the actual evidence that it was settled, you wouldn’t be able to refute a new trade line on your credit report,” Viale said. Keeping good records is an important part of the debt settlement process, as well as confirming that the settlement has been reported to the major credit reporting agencies.

Speaking of credit reports, remember that a debt settlement won’t totally solve your credit woes.

“On the credit report, they could expect to see a severe delinquency on that account for the duration of the reporting period, which is 7 years,” Nitzsche said. “And then the account will also be marked as settled, instead of paid in full, so if someone were manually reviewing their credit report they would see that.”

Not only could that affect your ability to get credit in the future, it could also impact your relationship with current creditors.

“Sometimes when a lender sees that you have settled with another lender, they may become concerned,” Randy Padawer, consumer education specialist for Credit.com partner Lexington Law firm, said. Many creditors conduct regular account reviews and look at your credit report in the process, so they may see the debt settlement and use that to make decisions about doing business with you. “They may close the account. They may enforce a default APR. There are lots of things in that regard that can happen and consumers need to know about these things.”

On top of all that, there’s a potential tax liability for debt settlement. If the difference between your total debt and the settlement exceeds $600, you can expect to receive a 1099-C, indicating you need to pay taxes on the canceled debt.

If you’re looking at your credit card balances and wondering what’s the best way out, debt settlement warrants careful consideration.

“Attempting to settle your debt is better than simply declaring bankruptcy, which will disrupt your credit reports and scores and for a longer period of time,” Padawer said.

Think about the potential credit consequences and if an alternative plan, like working with non-profit credit counseling agency or figuring out a way to tackle your debt on your own, would result in less damage to your overall financial health. As you weigh your options, remember you can get a free credit report summary every 30 days on Credit.com, to see how your debt currently affects your credit scores and how they could be affected by your debt-payoff solution.

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