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We spoke with Bruce McClary of the National Foundation for Credit Counseling (NFCC) about how the two differ, what borrowers often overlook and a common misconception about charged-off debt.
Debt settlement vs. debt forgiveness
- What is debt settlement?
- When is debt settlement the right move?
- What is debt forgiveness?
- When debt forgiveness applies
- Need more advice?
What is debt settlement?
Debt settlement is the process of negotiating with a creditor or debt collector to accept less than the full amount you owe. You can negotiate yourself or hire a settlement company to do it on your behalf, McClary tells CNBC Select. Once you fulfill the terms of the agreement, the remaining balance covered by the settlement is generally no longer owed. Be sure to get the agreement in writing.
Settling a debt doesn't erase its history from your credit report. The account may be reported as settled for less than the full balance, and its payment history, including any missed or late payments, can remain on your credit report. Negative information generally stays on your report for up to seven years.
When is debt settlement the right move?
Debt settlement may be worth considering when you're struggling to keep up with your debt and other options aren't realistic, McClary says. Because it can negatively affect your credit and potentially result in a tax bill, it's generally worth exploring alternatives first, such as a debt consolidation loan or a debt management plan.
If you pursue debt settlement, be cautious of how companies market their services. "Marketing for debt negotiation services can seem aggressive and ever-present for consumers, especially at times when more people are struggling to stay afloat financially," McClary says. Some offers are legitimate, but others "play fast and loose with their messaging about quick debt elimination and outcomes that are not representative of their typical customer."
If you need help deciding where to start, our list of the best debt relief companies highlights options for consumers considering debt settlement. Freedom Debt Relief, for example, offers customer service seven days a week and has an A+ rating from the Better Business Bureau. Its program guarantee also provides for a refund of certain fees if the total cost of settling enrolled debts exceeds the amount of debt enrolled, subject to the program's terms.
Accredited Debt Relief also has an A+ BBB rating and a strong customer review score.
Freedom Debt Relief
Learn MoreMinimum debt
$7,500
Fees
The settlement fee is 15% to 25%, depending on the state and amount of enrolled debt. $9.95 escrow account set-up charge and $9.95 monthly service fee
Availability
Not available in Colorado, North Dakota, Oregon, Rhode Island, Vermont, West Virginia, Wisconsin, Wyoming or Washington, D.C.
Highlights
Freedom Debt Relief has resolved over $20 billion in outstanding debts since 2002. It offers free credit card debt relief consultations.
Pros
- Debt requirement is lower than many competitors
- Customer service available seven days a week
- A+ Better Business Bureau rating
Cons
- Not available in all states
Accredited Debt Relief
Learn MoreMinimum debt
$5,000
Fees
Settlement fee averages 15% to 25% of enrolled debt depending on the state
Availability
Options and evaluations in all 50 states + DC
Highlights
Started in 2011, Accredited Debt Relief has helped over 1.3 million clients resolve over $15 billion in debt.
Read our review of Accredited Debt Relief
Pros
- Free consultation and educational resources
- A+ rating from the Better Business Bureau
Cons
- Need at least $5,000 in unsecured debt to enroll
- Higher settlement fee than some competitors
What is debt forgiveness?
Debt forgiveness occurs when a creditor cancels some or all of the debt you owe. It can be the result of a successful debt settlement, in which a creditor agrees to accept less than the full balance, McClary explains. Once you meet the terms of the agreement, the remaining balance covered by the settlement is generally no longer owed.
The terms are often used interchangeably because both can involve paying back less than the original amount owed. However, debt settlement refers to the negotiation process, while debt forgiveness refers to the cancellation of the remaining debt.
When debt forgiveness applies
Debt forgiveness isn't automatic, and it doesn't always come without consequences. If a creditor cancels $600 or more of debt, it generally must issue a Form 1099-C, which reports the canceled amount to the IRS. The forgiven amount may count as taxable income, although certain exceptions and exclusions apply, McClary says. "People are so focused on the debt relief outcome that they sometimes overlook the part about a tax bill for the debt that was forgiven." Debt relief companies covered by federal telemarketing rules must disclose potential tax consequences, so it's worth asking about them upfront.
There's another common misconception worth knowing about: a charged-off debt hasn't necessarily been forgiven. McClary, who spent several years as a debt collector working with seriously delinquent accounts, says people sometimes assume that when a creditor stops calling or an account is marked as "charged off" on their credit report, the debt is no longer owed. That's not necessarily the case. "The debt can remain legally collectible after it is written off by the original creditor," he says.
In other words, don't assume you're off the hook just because a creditor has stopped contacting you. Confirm with the creditor or debt collector whether the debt has actually been settled, canceled or otherwise resolved.
Need more advice?
If you're not sure which option makes sense, start with a nonprofit credit counseling agency. A credit counselor can walk you through your specific situation, including eligibility for other programs, and help you weigh the costs, tax implications and credit impact of each path before you commit to one.
Money Management International (MMI), for example, provides credit counseling and debt settlement services. A counselor will assess your finances and help you develop a personalized plan without the high-pressure sales tactics sometimes associated with for-profit debt settlement companies. According to MMI, clients enrolled in its debt management plans save an average of $48,850 and pay off their debt about 26 years sooner than they would by making minimum payments alone.
Money Management International
Learn MoreHighlights
The largest nonprofit credit counseling organization in the U.S., MMI delivers both debt management and debt settlement plans, with online financial education tools and 30 branch offices.
Minimum debt
$0 ($2,000 for debt settlement plans)
Fees
Initial set-up fee ($33-$75) and ongoing monthly fee ($25-$69). Fees vary based on state and debt amount.
Availability
Operates in all 50 U.S. states and Washington, D.C.
Pros
- Offer credit counseling and debt relief.
- Debt management plans available nationwide.
- High success rate in reducing interest rates.
- A+ rating from the Better Business Bureau and overwhelmingly positive reviews.
Cons
- Initial setup fee and monthly subscription.
- Debt relief programs not available in all states.
- Clients must close any enrolled credit cards.
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Meet our experts
At CNBC Select, we work with experts who have specialized knowledge and authority, grounded in relevant training and experience. For this story, we interviewed Bruce McClary, SVP of membership and communications at the National Foundation for Credit Counseling (NFCC).
Why trust CNBC Select?
At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every debt relief article is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of debt relief products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.
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