Understanding Debt Settlements and Charge-offs

Couple stressed about debt

When dealing with overwhelming credit card debt, many credit card holders consider engaging in a debt settlement or wonder if their debt will become a charge-off. While these two options both commonly result from credit card debt getting out of hand, they are not the same thing.

Debt Settlements Explained

A debt settlement occurs when you or a third-party negotiates with a credit card company to pay a lump sum of funds that is less than the full amount of debt you owe. Essentially, after these negotiations you "settle" your debt for less money.

You typically must establish a settlement with each creditor. However, credit card companies are not required to participate in debt settlement agreements. Therefore, there is no guarantee that you will be able to engage in a debt settlement with any or all of your creditors.

Help with Settlements

Although you may negotiate with credit card companies to create debt settlement agreements, according to the Federal Trade Commission (FTC), for-profit companies typically offer this service. These companies negotiate with credit card companies on your behalf to reach a settlement amount. The FTC states that, many times, the company asks you to place funds into an escrow account so that those funds begin to accrue interest that can be used toward your settlement payment.

Debt settlement companies charge fees for their services. The amount of fees varies and is established by each company. You must agree to the company's fee structure prior to its working on your behalf. However, the company:

  • Cannot charge you for debts that are not settled - Therefore, if the credit card company refuses to engage in a debt settlement agreement, you do not have to pay the company.
  • Can only charge you for the portion of the debt it settles - If the company is working to create settlement agreements for five cards, but only succeeds in creating an agreement for one card, it can only charge you a fee for the one agreement.

Effects of a Debt Settlement

Bankrate.com says that debt that has been settled is marked as such on credit reports by phrases such as "settled for less than amount due" or "partial payment accepted." Therefore, even though the amount owed appears as "0" on your report, there is also a clear indication that you failed to pay the whole amount you owed. Credit reporting agencies treat these phrases negatively and reduce your score and creditworthiness as a result.

There are also potential tax consequences from debt settlement. The Internal Revenue Service treats any funds excused by a credit card company pursuant to a debt settlement agreement as income. Therefore, you may end up paying taxes on the amount of debt that was excused by the credit card company.

Charge-Off Explained

A charge-off is an accounting entry; it is used to identify a credit card issuer's loss in the form of an unpaid credit card debt. It is not a payoff of the amount of money owed on the debt or an agreement to take less money for the debt.

According to CreditCards.com, a charge-off occurs when a credit card balance is removed from an issuer's books and "charged" against its loss reserves. Essentially, a charge-off occurs when a credit card issuer recognizes that it is unable to collect on a debt owed and identifies that debt as a loss on its accounting paperwork. A charge-off typically occurs when a debt is more than six months overdue.

Consumer Obligation

A charge-off does not mean that the debt is erased or that a debtor does not have to pay the debt. Usually, a credit card company sells the outstanding debt to a collection agency, albeit usually for less than the full amount owed. This way, the credit card company still obtains some reportable revenue losses for tax purposes and the collection agency obtains income in the form of a collectable debt.

Effects of a Charge-Off

According to the FTC, charge-offs to stay on your credit report for up to seven years. Therefore, your credit report will identify charge-offs established for debts you owed for a lengthy period of time. Because they show that you failed to pay your debts on time, charge-offs are treated negatively by credit reporting agencies, resulting in your credit score and creditworthiness being reduced.

Fox News reports that any portion of a debt excused by either the credit card company or the collection agency to which the debt was sold can be considered taxable income if it is over $600.

Distinctions Between Settlements and Charge-Offs

Settlements and charge-offs are appropriate in different circumstances, have different potential tax ramifications, and affect credit reports in different ways. If you are facing overwhelming debt and are considering debt settlement (or you think a charge-off may be imminent), seek advice from a financial professional to figure out your options.

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Understanding Debt Settlements and Charge-offs