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 in collections, 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.

 

Example. 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.

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. (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.

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