Even the best of us have times when paying our bills gets tough: An unexpected car repair, an emergency furnace fix, or a medical bill we didn't foresee can leave us scrambling. Unfortunately many of us live paycheck to paycheck, and a surprise expense can create a vicious cycle of "never quite catching up" and with that, harassing calls from creditors that can become an everyday occurrence.
Some companies offer debt consolidation and debt settlement as a way of regaining financial footing. But what is debt settlement and is it really a better alternative than bankruptcy?
Debt Settlement 101
If you are stuck between paying a bill and paying the rent, you are in obvious need of financial relief. Debt settlement is a service whereby a company works with your creditors to negotiate a pay-off of your outstanding balances. The company then offers you a loan to cover those settlements, and the loan is paid back in one monthly payment. Generally, that loan is repaid over 12-24 months.
But debt settlement comes with a pretty steep price: The Internal Revenue Service requires that you pay tax on any amount of debt that is forgiven. So, for example, if $20,000 worth of debt is forgiven, you will be paying tax on that $20,000. Even if you are in the lowest tax bracket of 10%, your tax burden for the forgiven debt would be $2000. If you find yourself just a couple of tax brackets higher--28%--you would be responsible for $5600 in tax.
Is bankruptcy a better answer?
Those are pretty stiff penalties and if you are already in financial straits, having to pony up money for the IRS may be a lot more frightening that paying it to a creditor. After all, the IRS can seize your wages, your bank accounts and your property. Debt settlement, too, leaves you with a black mark from the creditors you settled with: The accounts are closed and reported to the credit bureaus. In general, you could see your credit score plummet by up to 100 points.
Bankruptcy, on the other hand, is handled on a flat fee. All debts are discharged and there is no need to pay the IRS taxes on the discharged amounts. While your credit will take a hit, most people find that within about three years they are able to apply for, and receive, credit.
If you are looking into debt settlement, why not also talk with an experienced bankruptcy attorney? A sound fiscal future depends on you exploring all options, and deciding which gives you the best outlook for financial health.