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Expert Q&A

There’s a cost to paying less than you owe

Summary

Before you jump at the chance to pay less than what you owe, think about what settling your debt will end up costing you.

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Dear To Her Credit,

My husband owes Lowe’s $10,800, mostly from building our deck and remodeling the bathroom. Because of some recent setbacks, we’ve been falling behind on our credit card payments. As of next month we’ll be two months behind on our Lowe’s card.

We just received a large sum of money. We hope to use it to clear as many of our debts as possible.

My husband called Lowe’s to see what the bottom line for payoff would be, and they easily offered that on our payment due date next month it will be $7,600. If we settle for that, how will it affect our credit? We sure like the savings as it will allow us to pay another creditor as well. — Bonnie

Dear Bonnie,
Before you jump at the chance to save $3,200, think about what settling your debt for less than what you owe will end up costing you.

Your credit score will certainly take a hit if your credit report shows your Lowe’s account as “settled” instead of “paid.” The more creditors it shows you settled with, the worse it looks.

It only makes sense — you spent $10,000, you get to keep the new deck and remodeled bathroom, but Lowe’s gets to take a $3,000 loss. The purpose of a credit history is so potential creditors have some idea what to expect when they deal with you. It’s like a Better Business Bureau in reverse.

Imagine you are thinking about buying something from a local business, but you check it out with the Better Business Bureau and notice — whoa — this business has a history of not keeping its promises! You’d probably go elsewhere.

Banks do the same thing with credit applications. The difference is they may still extend credit to you after they see you settled a debt in the past. You just won’t get the preferred interest rate. You’ll pay more — possibly much more. You could spend a lot more in higher interest expense than you saved by settling with Lowe’s.

Even worse, if you buy or refinance a house in the near future, having a settlement on your credit history could cause banks to offer you a higher rate on your mortgage. Every additional percentage point dramatically increases the amount of interest you pay over the life of the loan.

You could ask Lowe’s to mark the account as “paid” instead of “settled” on your credit report. You should be aware, however, that you are asking them to lie on your behalf. Lowe’s is under no obligation to put anything but the truth on your report.

I see one more problem with taking 100 percent of the money your husband received and using it to pay off debts. You apparently don’t have a financial cushion, or you wouldn’t be behind in your payments. If you use all the money to settle your debts, you still have nothing to fall back on. The next unexpected expense or dip in income that comes along, and you go into debt to pay bills again. It’s a frustrating cycle of going deeper into debt and trying to get back out again and again.

The only way to break that cycle is to start planning ahead. Try to build up a reserve equal to six or nine months’ living expenses, as well as a savings plan for future projects, trips or luxuries.

Lastly, you’ll get an unpleasant surprise at tax time if you settle your debt. That $3,200 is likely taxable income that could bump up your taxes due by $800 or more.

Here’s what I recommend:

Skip the settlement. Instead, take about half of the money you’ve received and start paying down your debts. Put the most money on the accounts with the highest interest rates first. If two accounts have the same rate, pay the smallest account off first. With the accounts paid down considerably, your monthly minimum payments will be smaller, making life easier.

Put the rest of the money into savings. Add to it faithfully. Even putting $25 into savings every month gives you a sense of control.

Beware of short-term fixes. The money you and your husband have received can help you get a new start by lowering your debt and giving your savings plan a head start. That may not be as immediately gratifying as wiping all your debt out at once. But if it helps you and your husband start practicing good financial habits, it will help put you in control of your finances for the rest of your life.

See related:  Beware of IRS tax bite that may follow canceled debt, 8 myths about settling credit card debt

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