If you can’t pay back a debt you may be able to settle it for less than what is owed. The goal in doing so is pretty straight forward — you want to get the creditor to accept a lower payment amount than the current balance on the loan or account. However, getting there can prove to be a challenging task and there are some mistakes you’ll want to avoid when trying to settle a debt.
1. Having Unrealistic Expectations
You may have heard you can settle a debt for pennies on the dollar, in the 10-25% range. That may be idealistic, so you shouldn’t expect it to go that way.
“While you may be able to negotiate down your debt, it’s important to remember that lenders are typically for-profit businesses accountable to shareholders,” John Schneider of the Debt Free Guys, and Credit.com contributor, said.
2. Overlooking Tax Consequences
Any time a debt is forgiven or settled, the IRS treats the forgiven amount as taxable income, and the creditor will most likely issue you a 1099-C. If you don’t keep this in mind, you may be faced with a surprise when Tax Day comes along.
“You’re not done paying for your debt when you send your settlement check,” Schneider said. “However, the amount of tax you may owe on this income or settlement amount will depend on other assets you have.”
3. Negotiating Too Early
“It seems counter-intuitive, but the more you demonstrate your inability to pay your lender back, the more inclined your lender will be to negotiate,” Schneider said. “Missing a few payments wouldn’t qualify.”
Missed payments and prolonged delinquencies will have a big effect on your credit, but it’s important to understand going in that many credit card companies may not be willing to negotiate with you until you are at least 90 days delinquent. In addition, being premature in the process may refer to the fact that you don’t have a full grasp on your financial situation.
“The ‘too early’ would be that you should have a budget and [know] what is possible before negotiating,” Thomas Duffany, an Accredited Financial Counselor, said. (For more, you can read this guide on tips for negotiating with creditors.)
4. Not Getting Help Negotiating
The person you talk to on the other end of the line at the credit card company or the collections firm is a professional whose skills may be intimidating.
“The person who negotiates for the lender is an expert at negotiating,” Schneider said, so asking for help might be a good option. “If you need to bring in a friend or a colleague more skilled with negotiating to speak on your behalf it may be worth it.” There are also professional organizations that can help negotiate — if that’s the route you choose, consider reading this guide that goes over 14 questions you should be asking a debt settlement company.
“Navigating issues of debt can be stressful, confusing, and frustrating,” Rebecca Wiggins, executive director of the Association for Financial Counseling and Planning Education, said. “It is important that consumers know where to turn and who they can trust to guide them to financial security.” She recommended consumers “look for a trusted professional with reputable credentials and comprehensive training.”
5. Settling for an Amount You Cannot Afford
It’s no good negotiating a settlement if you wind up defaulting on the new agreement, essentially putting you back in the same stressful situation.
“It is essential that consumers have an updated spending plan to understand income, expenses and debt,” Wiggins said. “It will also help to determine how much they can afford to pay toward debt.”
6. Not Getting the Agreement in Writing
Getting a creditor or collection agency to agree to a settlement is only part of the process — once you get them to agree, it’s essential to get the agreement documented in writing. Oral contracts are extremely difficult to enforce, so having a written agreement spelling out the terms of the agreement exactly will help you should you need to enforce the contract in court.
According to Todd Christensen, the director of education at the National Financial Education Center in Boise, Idaho, it’s important that “… anyone setting a debt should get in writing that the creditor will not sell (send to collections) any remaining amount not paid.” You’ll also want to outline the other terms of your agreement in writing.
As you continue to work on paying your debts, it’s a good idea to monitor the effects it’s having on your credit. You can view two of your credit scores for free, updated every 14 days, on Credit.com.
Image: Petar Chernaev
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