Expert Q&A

Settling debt has credit score, tax impact


With four credit cards in collections, she wonders about the impact of paying less than what she owes

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Dear To Her Credit,

I have four credit cards in collections. I am getting a settlement so I want to start repairing my credit. I have gotten letters to settle for less than I owe from some law offices, but will it reflect better on my credit if I pay the full amount? How long does it take for your credit to improve? In addition, I have heard if I settle I could have a tax liability. Would that impact on the money left over after the settlement? — Ivy

Dear Ivy,

If you can afford it, you are better off paying your debts in full than settling for less. For one thing, it’s generally the right thing to do. A customer spends the money at a store, the bank pays the store and the bank should expect to be paid by the customer.

For another thing, paying your bills in full is much better for your credit history.

As you’ve figured out, settling a credit card debt can have hidden costs not so far down the road. Settling four credit cards could lower your credit score significantly — enough to make you pay higher interest on future consumer loans and mortgages. Some of the money you save by settling is lost again to high interest expense. If you are buying a house in the near future, a higher interest rate could cost you far more than you save by settling your debt!

Then there’s tax liability. It won’t be equal to the amount you did not pay, but it will probably be between 15 percent and 25 percent of the amount, depending on your tax bracket. It may affect you more if you are on the edge of qualifying for certain credits and other benefits that are phased out for higher income levels. On the other hand, if you have a lower tax liability, the “income” from cancellation of debt may not affect your tax at all.

Because taxes are so complex, and so many calculations can depend on any one change to your return, the only way to know for sure how the cancellation of debt will affect you is to run the numbers on your return. If you use tax software, create a file using last year’s numbers, modified to the best of your ability, or use preliminary software for the year as soon as it is available. If the cancellation of debt is a large number, and you’re not comfortable estimating the tax impact yourself, consider having your accountant do it for you. It’s worth the cost to have the best information before you make a decision.

Settled debt stays on your credit history for seven years. However, it does the most damage in the first year or two, especially if you can show that you’ve made a clean start and you never miss a payment from that time forward.

If you can pay off your debts without depleting your emergency fund, go ahead and do it. It’s a great feeling to pay off debts!

If paying off your debts leaves you with nothing — no backup plan if you become unemployed or have a car repair, for example — you may be better off settling your debt. Too many people pay off debt, but forget to address one of the main causes of getting into debt in the first place, which is not having any money set aside for emergencies. They quickly find themselves right back where they started.

It’s great that you have received a settlement and you want to take care of your debts. Consider your options carefully, and take care of your credit!

See related: How much tax do you pay on canceled debt?, Settling delinquent debt won’t remove it from your credit report?

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