When you can’t afford to pay everything you owe, credit card debt settlement could help you get out of debt faster. You pay back a percentage of what you owe and in return, the creditor discharges the remaining balance. This may hurt your credit score, depending on the terms of the settlement you negotiate. Even so, as long as you are aware of the impact and have a plan to recover, settlement could be beneficial. It may provide the faster exit that you need to get a clean start without your existing debt weighing you down.

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There are two basic paths to credit card debt settlement

Debt settlement negotiations work in two basic ways:

  1. You can negotiate a settlement with a single creditor or collector.
  2. You can enroll in a debt settlement program to settle multiple debts.

The first path is something that you can either do on your own or hire a debt settlement attorney to do for you. It’s most common when you have one or two problem accounts already in collections. To use the second option, you usually must go through a debt settlement company. This option is best used when you have multiple debts that are behind or already charged off.

2 Ways Credit Card Settlement Works

Option 1: How to negotiate credit card debt settlement yourself with a single creditor

This basic credit card debt settlement process can vary. In some cases, the collector or creditor may contact you with a settlement offer. Then you decide if you want to accept it or make a counteroffer. In some cases, you can make the settlement with a small series of payments, instead of a single lump sum; however, this is less common.

Option 2: How a debt settlement program works

When you have multiple debts to settle, you typically set up a debt settlement program through a debt settlement negotiation company. Using a debt settlement program generally follows this same basic process as individual negotiations. However, there are steps you may need to take before the negotiation can begin.

  1. The settlement company will create a “set aside” account where you deposit money to generate the funds you need.
  2. They help evaluate your budget to see how much money you have available to set aside each month; this amount is often significantly less than the total monthly payment you’re making on all credit card debts.
  3. Once you generate enough funds, they approach one of your creditors to make a settlement offer.
  4. The creditor may counteroffer, in which case your settlement team negotiates to reach a final amount that all parties can accept.
  5. Once you reach a settlement and the creditor discharges the balance, fees are applied. Fees are typically calculated by taking a percentage of the original balance of the debt you settled.
  6. This process repeats with each creditor or collector until you reach settlements on all the debts included in your program.

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This type of settlement works for other unsecured debts!

Credit cards aren’t the only type of debt that you can settle using the methods described on this page. This type of settlement may also work for almost any unsecured debt:

  • Credit cards
  • In-store credit lines
  • Bills that have gone to collections
  • Payday loans
  • Unpaid medical debt collections

So, if you have more unsecured debts that just credit cards, you may be able to roll them into the same settlement program. This can provide one solution to take care of a wider range of the debt challenges that you face.

It’s worth noting that there are also settlement programs for tax debt and private student loans. Settlement usually doesn’t work for most secured debts, like mortgages and auto loans. That’s because the lender can simply repossess the collateral (your home or car) if you don’t pay what you owe.

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Pros and Cons of Credit Card Debt Settlement

ProsCons
It usually takes less time than other solutions, especially compared to making minimum paymentsSettlement typically generates negative items on your credit report, which may decrease your credit score
You can get out of debt for less than you oweYou could be on the hook for income taxes for the settled debt

Credit card settlement benefits by the numbers

In June 2014 the Center for Responsible Lending conducted a study to evaluate the impact of reputable debt settlement services following the implementation of new regulations by the Federal Trade Commission. Here is what they found…

  • The average client included 6 debts in their unsecured debt settlement program
  • Total debt enrolled in the program averaged out at $30,357
  • The average settlement percentage was 48%

When a settlement may be better than consolidation

If you have credit card debt to repay and minimum payments aren’t working, you generally have two options (not including bankruptcy):

  1. Debt consolidation
  2. Debt settlement

A settlement is usually the better option when you simply want the fastest exit possible without declaring bankruptcy and don’t care about credit score damage. It’s especially useful for debts that are already charged off. That typically happens after six-nine months of nonpayment. The creditor freezes the account, moves it to charge-off status and counts it as a loss for the company. They either sell it to an outside debt collection agency or send it to their in-house collections department.

At this point, in either case, all interest charges and late fees on the account freeze. Federal law says that a creditor or collector cannot apply interest charges or additional late fees to a charged-off balance. They can only collect the amount listed when the account was charged off.

This means that there’s less benefit to consolidating the debt. The biggest advantage of credit card debt consolidation is to reduce or eliminate the interest rate applied to each debt. If no new interest charges can be applied and rates don’t matter, then consolidation offers less of a benefit.

This means that once a debt goes to collections, debt settlement should be on the table as a possible solution. Consider carefully if you’re willing to accept some credit damage. If you are, then you should seriously consider settlement. If you want to avoid credit damage, then you should look at other options first.

Debt Settlement Taxes and How to Avoid Them

When you settle a debt for less than the full amount that you owe, you could be subject to income taxes. Any principal that you do not pay back is considered “canceled debt.” The IRS treats canceled debt as a source of income – it’s money you received without paying your creditors back. But that means that it counts as taxable income.

The good news is that there is a way to avoid paying taxes on canceled debt. All you need to do is show the IRS that the debt was canceled during a period of financial hardship.

How tax filings work for canceled debt

When a debt is forgiven or canceled in a settlement, the creditor must complete a 1099-C. It will report your Cancellation of Debt Income (CODI). This happens for any debt settled that totals over $600. So, you don’t need to worry about this if the settled debt amount is less than $600.

In all other cases, you should receive a copy of the 1099-C from the creditor. They also send one to the IRS, which is why you can’t just ignore it. Instead, you need to apply for an exclusion. You can qualify for an exclusion if you can show that the debt was canceled due to insolvency. In other words, you didn’t have the money to pay!

To qualify for an exclusion, you must complete IRS form 982. It’s worth noting that this is not exactly an easy, hassle-free form to fill out. It includes a title form called the Reduction of Tax Attributes Due to Discharge of Indebtedness that is fairly exhaustive. We recommend working with a certified tax preparer or resolution service to ensure this is done correctly. If you don’t qualify for the exclusion, then you can expect to pay taxes on the settled debt on your next income tax filing!

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Debt Settlement and Your Credit Score

Q:How does credit card debt settlement appear on your credit report?

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A: Each time you settle a credit card debt, it will usually create a negative item on your credit report. This item is reported for seven years from the date the account originally became delinquent. It may be possible during the negotiation that you ask the creditor to “re-age” your account following the settlement. They basically agree to update the information in your credit report to show as “current” in exchange for your payment. If the account is in collections, you can attempt to negotiate pay for delete. The collector reports to the credit bureaus to remove the collection account from your report.

This can remove the negative credit report information, so you’re not bogged down by settlements as you move forward. However, be aware that creditors and collectors are required by law to report accurate information about consumer credit use. So, it’s not always guaranteed that these tricks will work. Even if the creditor or collector initially agrees to remove a collection account or re-age it, the negative information could reappear later.

So, it’s best to go into debt settlement with the understanding that it will cause some damage to your credit.

Note: If you work with a debt settlement company, all accounts will appear in your credit report as “paid as agreed.”

Q:How does a credit card settlement affect your credit score?

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A: Credit card settlements count as part of your credit history, which is the biggest factor used to calculate credit scores. Credit history counts toward 35% of the total weight in a credit score. So, negative information like settlements can have a significant impact on a consumer’s credit score.

On the other hand, the size of the impact depends on where you start. If you have excellent credit with no prior negative information, then a settlement would have a notable impact. However, if you have bad credit already caused by a number of other negative items, the impact may be less.

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Article last modified on April 13, 2020. Published by Debt.com, LLC