The cons of debt settlement include significant credit score damage, potential tax liabilities on forgiven debt, high fees from settlement companies, the risk of increased debt from interest/late fees while waiting, no guarantee creditors will agree to settle, and the possibility of being sued or facing collection harassment. The process is long, stressful, and carries risks like scams, making it a last resort.
Debt settlement can cause damage to your credit up to seven years. It's also an industry that has long been plagued by bad actors who charge customers fees before settling any of the debt they owe.
Debt settlement can hurt your credit, hinder your long-term financial prospects, come with hefty fees and have tax implications, among other risks. Scams are also possible. Debt settlement can allow you to pay off your debts for less than you owe, but it has risks you should be aware of before considering it.
Completion rates vary between companies depending upon a number of factors, including client qualification requirements, quality of client services and the ability to meet client expectations regarding final settlement of their debts. Completion rates range from 35% to 60%, with the average around 45% to 50%.
Debt Settlement Tax Consequences
You likely will be charged taxes on the forgiven amount of debt after a debt settlement. The IRS considers any debt cancellation of $600 or more as additional income — and taxable — even though you didn't actually receive any money.
In general, if your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable. If taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.
The "777 rule" in debt collection, also known as the 7-in-7 rule, is a CFPB regulation (Regulation F) limiting calls: collectors can't call more than 7 times in 7 days for a specific debt, nor call within 7 days of a conversation about that debt. It aims to prevent harassment, applying to calls, texts, and emails, though exceptions exist, and the presumption of compliance can be rebutted by aggressive call patterns like rapid succession or highly concentrated calls.
Credit Score Damage: One of the major downsides of debt settlement is the negative impact on credit scores. The process can lower a credit score by 100 points or more, depending on the individual's credit history. This can make it harder to qualify for credit, loans, or favorable interest rates for several years.
There's no definitive timeline for home purchase post-debt settlement, as it depends on your financial condition. However, according to most financial experts, the waiting period should be at least 2-2.5 years after debt settlement before you apply for a home loan. The more you wait, the better your finances get.
In many cases, once an account has gone to collections the worst of the damage has been done. Settling is often the fastest and most affordable way to clear away these kinds of debts, especially if you're dealing with multiple debts in collections.
That said, most successful settlements typically result in paying 30% to 50% less than the original balance. So, for example, if you owe $10,000 on a credit card, you might reasonably offer $5,000 to $7,000 as a lump-sum settlement.
The best way to pay off debt involves choosing a strategy like the Debt Avalanche (highest interest first for savings) or Debt Snowball (smallest balance first for motivation), making more than minimum payments, cutting expenses to free up cash, and potentially using balance transfers or consolidation loans if your credit is good, all while tracking spending and building a small emergency fund first.
Before agreeing to work with a debt settlement company, there are risks that you should consider:
By taking the right steps to rebuild your credit, like using secured cards wisely and making all payments on time, you can gradually work your way back into the credit world. It won't happen overnight, but with patience and persistence, using a credit card again after debt settlement is possible.
Settlement risk refers to one or more parties failing to deliver as agreed in a contract, affecting financial transactions. This risk includes default risk, where a party fails completely, and settlement timing risks, involving delays.
The 2-2-2 credit rule is a guideline for building strong credit, suggesting you should have two active credit accounts (like cards or loans) for at least two years, with consistent on-time payments for those two years, often with a minimum credit limit of $2,000 per account, to demonstrate financial responsibility to lenders, especially for mortgages. It's a benchmark to show you can handle credit well over time, reducing lender risk and improving approval odds for major loans.
This validation information includes the name of the creditor, the amount you owe, and how to dispute the debt. If the debt collector doesn't or can't provide this information, it could be a scam. Never give sensitive financial information to the caller, at least not until you've confirmed they're legitimate.
According to the IRS, nearly any debt you owe that is canceled, forgiven or discharged becomes taxable income to you. You should receive a Form 1099-C, "Cancellation of Debt," from the lender that forgave the debt.
Common debt settlement mistakes include late negotiations, poor documentation, and compliance gaps. Learn how creditors can fix them to improve recovery.
Seek help from credit counseling services.
Most importantly, these non-profit credit counselors are usually free of charge. Credit counseling organizations can assist you with creating a debt management plan for all your debts by making a single payment to the credit counseling organization each month or pay period.