Debt Settlement Can Shrink Balances, But Add New Costs

A $10,000 credit-card balance that gets settled for less than the amount owed does not automatically translate into $10,000 of savings. The borrower may first spend months building a settlement fund, watching interest and late fees swell the account, while a separate company takes its cut and creditors turn up the pressure.

Debt settlement is a negotiation in which a creditor agrees to accept less than the full balance, usually in a lump-sum payment. For-profit settlement firms typically ask clients to deposit money into a dedicated account, then approach creditors once enough cash has accumulated. The account is supposed to remain under the consumer’s control, and the Consumer Financial Protection Bureau says borrowers should be able to withdraw their money without penalty.

The catch is the strategy often depends on stopping payments. That can trigger penalty interest, collection calls and negative credit-report entries. A creditor may sue before negotiations produce an agreement, and a settlement company cannot guarantee that every account will be resolved. If only some debts are settled, growing balances on the rest can consume the savings.

Fees vary by contract. The Federal Trade Commission says companies commonly charge a percentage of the debt enrolled or the amount saved, but they generally cannot collect those fees before settling at least one debt, reaching an agreement with the creditor and receiving a payment under that agreement. An upfront-fee demand or promise to erase debt for “pennies on the dollar” deserves scrutiny.

Taxes are another cost that borrowers often miss. The Internal Revenue Service generally treats forgiven debt as ordinary income and may receive the same information reported on Form 1099-C when at least $600 is canceled. Bankruptcy and insolvency can exclude some or all of that income, but the rules are technical and may require Form 982 or other tax reporting.

Before signing, consumers should compare settlement with direct negotiation, a nonprofit credit-counseling debt-management plan, consolidation or bankruptcy advice. Credit counseling usually aims to lower interest rates or monthly payments without asking borrowers to stop paying. Settlement is different. It trades payment relief for a period of deliberate default, with no assurance that the final bill, credit damage and tax consequences will fit the original sales pitch.