The Truth About Debt Forgiveness | US News

The Truth About Debt Forgiveness

Credit card debt forgiveness won't cure all of your money problems.

U.S. News & World Report

What Is Debt Forgiveness?

Close up of a young woman doing her bills in the kitchen

Even when your debt is forgiven, you may still owe taxes on it.(Getty Images)

When some people think about credit card debt forgiveness, it goes something like this: Your debt is totally erased, and you live happily ever after with no consequences. That would be amazing.

But the harsh truth lies somewhere short of "totally erased" and "no consequences." To be clear, debt forgiveness does exist, and it's possible to settle your debt for less than what you owe. But to get it totally erased is rare, and it usually requires an extreme measure, such as bankruptcy.

Read on to learn everything you need to know about debt forgiveness and what it means for your credit score and your wallet.

What we'll cover:

The best way to explain this is with an example. Let's say you have a $14,000 credit card balance and you're six months behind on your payments. At this point, your credit card company has sold your debt to a collection agency, so that's whom you'd be negotiating with.

You reach an agreement with the debt collector to pay back $10,000 in a lump sum or in installments. The amount of debt forgiven in this case is $4,000. This doesn't mean you can forget about the forgiven debt, though. Unfortunately, you might have to pay taxes on it.

But there are some steps you can take to avoid having to deal with a debt collector. If you take action as quickly as possible, you have an opportunity to talk to your credit card company before your debt is sold.

Ideally, if you're about to miss a payment on your credit card account, you'd call your credit card issuer before that happened. Fortunately, many credit card issuers are still sympathetic to consumers who have financial problems due to the pandemic.

But even if your problems are unrelated to COVID-19, you still need to call your credit card company as soon as possible. Ask to speak with the hardship department and explain your situation. But don't expect debt forgiveness at this stage.

At this point, you'll probably be offered a hardship plan. You'll have to pay the debt, most likely in full, but the issuer might lower your monthly payment or reduce your interest rate for a year.

This is designed to get you back on your financial feet. A hardship program gives you a little breathing room. And if you contact your issuer as soon as you know you have a problem, it can minimize the damage to your credit score.

These programs usually only last for 12 months, so it's a good option if your financial woes are temporary. But if a year of leniency would be the equivalent of throwing a glass of water on a forest fire, then you need a better solution.

If you decide a quick fix isn't in the cards, don't despair. There are several debt relief options to check out. I've focused mainly on credit card debt, but here are a few options that help you deal with other types of debt as well. For example, you might have medical expenses you incurred from a sudden illness. Medical debt can be difficult to pay off without some type of assistance.

Here are some options for those who need help dealing with their debt:

With a debt management plan, you pay the full amount you owe over three to five years. But you might still get relief with a reduced interest rate, for example.

These programs are managed by a credit counseling agency. But not all agencies are legitimate. So make sure you reach out to an agency accredited by the National Foundation for Credit Counseling.

You can get a free phone consultation to understand your options. Reaching out to a credit counselor doesn't mean you'll have to agree to a debt management plan, or DMP. And seeking counseling, by the way, does not end up on your credit report and doesn't affect your score.

But if your debt situation seems insurmountable, then a counselor might suggest a DMP as a credit card debt relief option. For some situations, this might be a better choice than bankruptcy.

Some debt relief companies will tell you to stop making payments, so you go into credit card default on several accounts. At that point, they negotiate on your behalf. But by now, your credit score is in the trash heap.

According to the Federal Trade Commission, these companies often engage in deceptive and unfair practices. Among other things, they might charge fees upfront, claim a new government program will wipe out your credit card debt or "guarantee" you'll get a huge amount of debt removed.

Some programs require you to deposit money in a savings account for 36 months or more. Many people have problems making the payments and drop out of the program. Be careful if you go this route. Check out the company you're considering with your state attorney general's office.

It's possible to negotiate with a collection agency on your own. This could work, but you need to be careful about what you say when you talk to debt collectors. The FTC enforces the Fair Debt Collection Practices Act, which protects you from deceptive and unfair debt collection practices. You need to be aware of your rights so you can protect yourself.

Depending on your financial situation, you might be able to negotiate a lump-sum payment or make installment payments on a reduced amount.

But heed this warning: Don't trust oral promises from a debt collector.

Get your repayment plan in writing, and don't make any payments before you do. This can be legally complex, so you might consider getting an attorney to help you get through this as smoothly as possible.

This isn't technically debt relief because you do have to pay the bill. But if you consolidate your credit card debt, for example, on a balance transfer credit card or via a personal loan, you're likely to be charged less interest on your debt while paying it off.

If you still have good credit, you might qualify for a balance transfer credit card that offers a 0% introductory annual percentage rate for about 12 to 18 months. The length of the intro period varies by card.

If you can't qualify for a balance transfer card, a debt consolidation loan might help. Do some comparative shopping, and you might find a loan with a lower APR than the one you're stuck with right now. This approach still saves you money on interest. When you're in debt, every little bit of "relief" helps.

There's good news and bad news about this approach. The bad news is that "government debt relief programs" don't technically exist for most people. But the good news is that the federal government does take steps to protect you from scams, offers online advice at Dealing with Debt and provides services that help you pay your bills.

The Consumer Financial Protection Bureau was created to shield consumers from unfair practices. If you've been the victim of shady financial actions, submit a complaint to the CFPB. You can also find resources on its website if the pandemic is making it hard for you to manage your debt.

If you have served in the military, the Servicemembers Civil Relief Act, which was enacted in 2003, offers many benefits, such as interest rate caps and even debt forgiveness in some situations.

Remember our example with the $14,000 credit card debt balance and the $4,000 debt that was forgiven? For forgiven amounts that are greater than $600, the creditor has to send you an IRS Form 1099-C that shows the total amount forgiven.

Here's how to figure out if you owe taxes on that. You'll need to take a solvency test to determine if you were insolvent before you agreed to a $10,000 settlement. If the insolvency amount is less than the debt forgiven, then you owe taxes on the difference.

Let's keep it simple and say your total liabilities before the settlement were $14,000. And the fair market value of your assets equaled $12,000. In this case, you were insolvent by $2,000.

But this is less than the forgiven amount, which is $4,000. In this example, you'd have to pay taxes on the $2,000 difference. The income tax reporting on such matters can get complicated, so you might want to consult a tax attorney for assistance.

There are circumstances where you'd be better off declaring either a Chapter 7 or Chapter 13 bankruptcy rather than going for one of the debt relief options above. For example, if you can't cover the installment payments that come with a debt settlement agreement, you're just going to fall further down the rabbit hole.

Don't wait until you're on the brink of financial disaster. If you're barely making ends meet, that's a huge red flag. Make an appointment with a bankruptcy lawyer and review the pros and cons.

A debt collection account stays on your credit report for seven years starting from the date of delinquency. To make it worse, the credit card company that sold your debt to the agency might also be reporting your account as charged off.

Clearly, all this messes up your credit score. But when you're in debt, you have to pick an option that not only stops the bleeding, but also gets you back on your feet.

There really is no such thing as a free lunch when it comes to credit. But take comfort knowing that your score will start getting better way before the seven-year period expires. After two years, negative items on your credit report have less impact on your credit score.

Updated on Feb. 17, 2021: This story was originally published on an earlier date and has been updated with new information.

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