Should You Take a Settlement on an Old Debt

Creditors and debt collectors may never stop trying to collect on old debts, not as long as there’s still an outstanding balance. You might be contacted about debts years after they’ve dropped from their credit report. As an incentive to get you to pay these old debts, some creditors and collectors offer to settle the accounts with you. But before you take the offer, there are a few things you should know.

What is Debt Settlement?

Settling a debt means that you pay a fraction of the balance due and the creditor, or collector, cancels the remaining balance. Debt collectors commonly settle debts for 60%, 40%, and even 20% of the balance due. Generally, the older debts are, the lower the settlement the collectors are willing to accept.

The benefit to you is that the debt is taken care of and you no longer have to worry about being contacted about that debt. Creditors benefit because they get money on debts they’ve already counted as a loss. Debt collectors, who’ve purchased debts from the original creditor for pennies on the dollar, earn a profit as long as your settlement is more than what they paid for the debt.

Debt Settlement & Credit Reporting

Settled debts still listed on your credit report will be updated to show that you’ve settled the account. The balance should be reported as $0. The settlement account status will stay on your credit report until the reporting time limit for that debt expires. Generally, time limit is seven years + 180 days from the date the account first became delinquent.

Because a debt settlement is less ideal than full payment, your credit score might suffer after your credit report is updated. According to FICO, the company who created the FICO score, a debt settlement could cost your credit score up to 125 points depending on the other information in your credit report. You can avoid the damage by convincing the creditor to report the account more favorably, something they may not be willing to do unless you pay the full balance.

Impact on Your Taxes

You may also face tax implications on debts you settle. Businesses are required to report debt cancellations over $600 to the IRS and you’re required to include this in your taxable income on your next tax return. However, being insolvent by at least the amount of cancelled debt would allow you to claim an exemption. You’re considered insolvent when the value of your debts exceeds the value of your assets.

Should You Settle?

With this information, you might re-evaluate your decision to accept a settlement offer. Settling your debt will let you off the hook by paying a smaller amount of money. The settlement may go on your credit report, but if the negative account is close to seven years old, you’ll only have to live with the credit consequences for a few years. If you’re afraid of the tax consequences, talk to a tax professional about what a settlement means for you; the tax load may not be as much as you estimate.

Should you decide to accept a settlement offer, have the creditor give you a written agreement that outlines the settlement terms. The agreement should specifically say that your lower payment will fully satisfy the debt. Then, make your payment according to the terms of the agreement and breathe easier knowing you’ve taken care of at least one outstanding debt.

Sources: myFICO, IRS.gov