When a person is in financial trouble, one way of dealing with creditors is negotiating a settlement where the debtor pays a lump sum to the creditor. Typically a debtor will offer a small percentage of what is owed to the creditor and the creditor will then accept the settlement and forgive the debtor for any remaining balance.
There are a few drawbacks to this approach. The first is that debt negation can have tax consequences that the debtor is unaware of. The amount of the forgiven debt is often considered taxable income. For example, if a debtor settles a $10,000 debt for $4,000, then the debtor may have to pay taxes on the remaining $6,000 balance. Typically the debtor will receive a 1099 from the creditor at the end of the year. And the forgiven debt will be treated as income by the Internal Revenue Service.
The next most obvious drawback is that the debtor must actually have a lump sum of money available to pay the creditor. Most people in financial trouble do not have these funds available. To obtain these funds, many debtors will cash out retirement accounts. This will cause the debtor even worse tax issues. If the money is in, for example, a in a tax protected account, the debtor will have to pay taxes on the funds when they are removed from the account and then will again be taxed on the difference between the settled amount and the debt which was owed. In addition, the debtor will also have depleted his/her retirement account which can raise issues for the debtor when retirement rolls around. Not only will the debtor have less money in the account, but he/she will miss out on the interest which would have accumulated from the removed funds.
Another way that debtors acquire the funds to settle the debt is saving up. The problem with this is that creditors will typically only grant settlement to delinquent borrowers. That means that the debtor would need to stop making payments in order to get the settlement. However when one stops making payments on a credit card for example, the credit card will likely raise the interest rate to nearly 30% and then tack on countless fees and late charges. A balance of $500 can quickly grow to twice its original size. When the debt is finally settled, the debtor might be paying half of the debt, but the whole of the debt will be more than the person owed to begin with.
Not making the payments can also result in the creditor pursuing legal action against the debtor. The creditor can sue the debtor and obtain a judgment against them and then start garnishing the debtor’s wages or levying their bank accounts making it all the more impossible for the debtor to ever come up with enough funds to settle the debt. A person who has hired a debt negotiation company is still vulnerable to these collection efforts.
Another issue which debtors often run into is that they do not obtain the proper paperwork from the creditor to prove that the debt has been settled and the debtors later find themselves dealing with a collection agency attempting to collect on the debt which was already settled. Creditors will often sell bad debt in bulk to collection agencies for pennies on the dollar. The collection agency then attempts to collect on the debt. If they are unable to get any funds, they in turn sell it to a new collection agency and then that collection agency attempts to collect on the debt. If the debtor who settled the original debt does not have the proper documents to prove that the debt was settled, the debtor will have a difficult time dealing with the subsequent collection agencies.
Another problem with debt negotiation is debt negotiation companies themselves. These companies often have a debtor pay them a monthly payment which they then hold in escrow awaiting enough funds to effectively negotiate a settlement. Many of these companies will assign most of the initial payments to their fees.
Some of these companies fail to disclose that they cannot protect an individual from collection activity while the individual is attempting to save money for a settlement. Many debtors are caught by surprise when their wages are garnished because they believed they were offered some type of protection by the debt negotiation company.
In some circumstances, debt negation can be a real benefit to a debtor. However, the pitfalls are many and need to be heeded and weighed before choosing this route to deal with financial difficulties.