If you're trying to free yourself from the burden of credit card debt, you have a number of options available. If you lack the means to pay the debt in full over a reasonable period of time but are unable or unwilling to file bankruptcy, debt settlement might be an option. (Learn about other options for dealing with debts.)
How Does Credit Card Debt Settlement Work?
Debt settlement involves making an offer to the credit card company to settle the amount you owe for a lesser amount. If the creditor accepts, you will need to pay the entire settlement amount up front, in one lump sum. (For help in crafting a settlement offer, get Nolo's eForm Offer to Settle Debt With a Reduced Lump Sum Payment.)
A credit card company might accept a settlement if you're very delinquent on your payments; it's often less costly for a creditor to accept a lesser amount in settlement than it is to send the account to collections, file a lawsuit, obtain a judgment, and then try to collect on the judgment.
Example. Janet has a $10,000 credit card balance. She hasn't paid the bill in nearly a year. She has managed to save $6,000, but she's so behind on other bills that she can't afford to save any more. She contacts the credit card company and offers to settle the account for $5,000. After some negotiation, Janet settles the debt for $6,000 and pays the entire amount to the creditor. The creditor writes off the remaining $4,000 balance and reports to the credit bureaus that the debt was paid in full by settlement for a lesser amount.
Pros of Credit Card Debt Settlement
Debt settlement has the following benefits:
- You are paying less overall on your debt in a much shorter period of time. Paying the debt off immediately means paying no more interest, and settling means you're paying even less than you currently owe.
- Debt settlement is less harmful to your credit than bankruptcy if your credit is not already poor.
Example. Ted owes $10,000 on his credit card. He is six months behind on his payments. Ted's six-month delinquency has hurt his credit; however, bankruptcy would cause his score to tank. If he only makes the minimum payment, with interest, it will take him 10 years to pay off, and he'll end up paying $18,000 total over that 10 years. If he successfully settles the debt, he will be rid of the debt immediately and pay less than $10,000.
Drawbacks to Credit Card Debt Settlement
On the other hand, debt settlement also has multiple drawbacks:
Debt Settlement Is Risky
If you stop making your credit card payments in an effort to save up enough money to offer a settlement, your credit card company can sue you, obtain a judgment, and garnish your wages and bank accounts. Even if you notify the creditor of your intent to settle, nothing legally stops the creditor from collecting.
Using a Debt Settlement Company Is Even Riskier
Many of these companies will advise you to default on your credit card payments and instead pay the money to them; after taking a monthly fee, they will put the rest of your payments into an account to accumulate a lump sum large enough to offer the credit card company. There are hundreds of fraudulent debt settlement companies advertising today, and it can be very easy to get pulled in by a debt settlement scam.
Josie owes $20,000 on her credit card and feels like she'll never get it paid off. Her monthly payment is $500. She hears an ad for a debt settlement company called ABC Debt Settlement on the radio and signs up. ABC requires Josie to pay the $500 she would normally pay to the credit card company to ABC instead. ABC takes a $120 fee and puts the remaining $380 in an account, promising to negotiate with Josie's credit card company when she accumulates $13,000. Although ABC notifies the credit card company of this arrangement, six months into the program, the credit card company sues Josie for defaulting on her payments and obtains a judgment against her for $20,000 plus interest. The credit card company then garnishes her wages, taking 25% out of every paycheck to satisfy the debt. (Learn more about why you should avoid debt settlement companies
Debt Settlement Creates Income Tax Liability
When a credit card company forgives any amount of the debt, the IRS and your state government will perceive the debt forgiveness as income to you. The difference between you original balance and the settlement amount is taxable income, and you will have to pay taxes on it, unless you qualify for an exception or exclusion. (To learn more, see Tax Consequences When a Creditor Settles a Debt
Example. Claire owes $12,000 on a credit card and successfully negotiates with the credit card company to settle the debt for $8,000. She pays $8,000 to the credit card company, which forgives the debt and reports it paid in full. The credit card company reports the settlement to the IRS, which notifies Claire that she must pay taxes on $4,000, the amount the credit card company forgave. To the IRS, the settlement was equal to the credit card company giving Claire $4,000.
Generally, most people are able to work out settlements with their credit card companies without getting assistance. But if you need help handling the negotiations, consider hiring a debt settlement lawyer. (Learn more about when hiring a lawyer to help you might be a good idea.)