debt

The true cost of debt settlement

Steve BucciQuestionDear Debt Adviser,
My wife's credit is very bad. Recently, she received a letter from a collection agency offering to settle her debt-in-arrears from $660 to $50. I'd like to help my wife begin repairing her credit, but I wonder, what's to stop this agency from coming after her for the rest, or another agency from seeking the balance?
-- M. Caz

AnswerDear M.,
The settlement offer for your wife's $660 debt is a good one. In fact, I call it a great one, but you will need to do it right to keep the fallout to a minimum.

Before you act on the offer, however, be aware that if the goal is to begin to repair your wife's credit, settling the debt for less than is owed will not help reach that goal. From a credit reporting standpoint, the account will be reported as a paid settlement and not as paid in full. A paid settlement will probably not lower her credit score any more than the collection account has already, but potential lenders do not like to see settled accounts. So, while the credit score impact may be small, the credit underwriting impact may be larger.

To help improve her credit, if you or your wife has the money to pay the debt in full, you might consider doing so.

Steve's quick tips
  • Get all terms in writing.
  • Keep copies just in case.
  • Try to address the underlying problem.

Should you decide to take advantage of the settlement offer, I recommend that you correspond with the collection agency in writing and let them know that you would like to settle her debt as stated in the letter. Request that the collector send you a written agreement detailing the settlement offer and how they intend to report the account to the credit bureaus.

Once you receive the written agreement, make the payment and send it and a copy of the agreement back to the collector via certified mail with a return receipt request. To be super safe, I'd use a bank check or money order, not a personal check. This will keep your bank account numbers out of sight in case there are other debts that may also be in the collection process.

To handle any further attempts to collect the debt, I suggest that you keep copies of the settlement agreement and a copy of your payment, (canceled check, money order receipt, etc.) If anyone contacts you in an attempt to collect the debt, let them know that it has been paid and offer to send them copies of the settlement agreement and payment method.

One last thing to keep in mind when settling a debt: If the amount of debt forgiven is greater than $600, and in your case it will be, the forgiven amount is reported to the IRS. The IRS treats forgiven debts as income. You will receive a 1099 form in the amount forgiven, in your wife's case $610, and will be required to report the amount on the form as taxable income on your next income tax return. So if your tax bracket is, say, 25 percent, you will owe an additional $153 in April.

Finally, to help your wife in her credit improvement quest, I suggest you begin by addressing whatever the problem was that led to the collection activity. I also strongly recommend that she develop a spending plan to help avoid future problems and to serve as the basis for an emergency savings plan. Having an emergency savings account to fall back on is the single greatest way I know of to keep out of financial and credit trouble. Your wife's credit score will improve as she makes on-time and as-agreed payments on her current credit accounts. The more time that passes with positive information added to her credit report, the less impact this negative item will have on her report and her credit rating.

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