Debt Settlements: A Cure for a Mess?

So you’ve gotten yourself in a mess of debt and are trying to find the best way to dig out?  Is it so bad that collectors have been calling and offering a settlement?  The idea sounds pretty good – you owe $500 and they’re offering to take $200 to make it all go away.  Should you do it?  What’s the catch?  Today, I’ll give you all the details on a debt settlement and when/how it should come into play in your debt situation.

Let me outline first what a settlement is.  A settlement is an offer, usually from the lender, where you will pay less than the full balance and the remainder is written off by the company.  Your credit report will reflect “settled in full” instead of “paid in full.” This isn’t as good as paying off the debt in its entirety, but with a settlement the debt will be 100% gone.  There are some potential tax implications, as debt forgiveness is considered taxable income.  But those are really about the only catches there are to it. When done with an honest collector (yes, they do exist), settlements can save you hundreds (or even thousands) of dollars.

In cases where you have a big mess to clean up, settlements can be a good idea as long as you’re smart about when/how to address them.  First, some die-hard rules:

• be ethically and morally upright in your dealings (consider Psalm 37:21 before continuing)
• make sure you have enough money to pay the settlement amount in FULL – don’t set up payments on a settlement
• get the settlement offer in writing
• never allow a collector electronic access to your bank account
• when you pay, send the funds certified (to prove they got there)
• request written confirmation that your payment settles the debt in full

These are often things collectors will buck against, but don’t proceed if they won’t play by those rules.

Credit Report Implications

As I mentioned earlier, paying off a debt by settlement will look different on your credit report than paying it in full.  Specifically, your credit report will reflect “settled in full” instead of “paid in full.”  Is this bad for your credit rating?  Maybe.  A judgment, bankruptcy, or completely unpaid debt is much worse.  A “paid in full” is better.  Balance your desire to have a good credit rating vs. the need to get out from the bondage of debt.

Tax Implications

Whenever there is debt forgiveness, of which a settlement is one form, it is possible that you’ll get a 1099 from one or more of the companies with whom you settle the debt.  Because you had debt forgiveness, the government treats that the same as income and so if you made $30,000 in a year and had $5,000 in debts forgiven that year, you’ll be taxed (potentially) on $35,000 of “income.”  Just be aware of this.  I’d rather pay taxes on this debt forgiveness, though, because in the scenario above, you’d only have a $750 tax liability on that $5,000 of debt forgiveness – a $4,250 savings in my book.

My Approach

If trying to tackle lots of debts, I would pay NO ONE EXCEPT the one(s) you can knock out at one given time.  For example, if you have five potential settlements that are $200 each and you can only pay one this month, ignore the others for now*.  Pay off the one you decide is most critical (maybe facing judgment, or the oldest – however you choose) and be done with it.  Next month, do the next one, and so on.  DO NOT SET UP PAYMENT PLANS FOR YOUR SETTLEMENT.  If you can’t do it all at once, don’t do it until you can.  My general advice is to work your way from the smallest debt up to the largest (similar to the Dave Ramsey debt snowball) but since these are probably very old debts already in collections, don’t open a can of worms until you’re ready to make a deal.

A Final Warning

* – There is some risk to this advice because not paying a debt could lead to court action (judgment) or similar. Some banks may even try to seize your airplane, if you have one, if you don’t pay your loans in time. If this happens, an airplane repo attorney can help you negotiate with the bank. It is also unbiblical to not pay your debts (Psalm 37:21) so don’t misunderstand my advice – TEMPORARILY put off the ones that you can’t pay while you handle the debts you can, one at a time.

Have you ever used a settlement to pay off debt?  Was it a good move or a bad one?  If you think it is a good idea, how do you feel about what Psalm 37:21 says about debt repayment?