When you get a windfall, pay debts in full to restore credit

A partial settlement will be taxable and bog down your score

Question for the CreditCards.com expert

Dear Credit Wise,
I have approximately $30,000 in credit card debt, and perhaps $1,500 in medical bills. I considered bankruptcy, but am awaiting a settlement from a personal injury case -- perhaps $100,000. I was advised by my personal injury attorney to hold off bankruptcy until settlement, approximately 60 days, at which time he would contact creditors about repayment. My question: Should we pay off the total amount of debts owed or offer a reduced payback? Which would enable me to restore my credit more quickly? -- M.S.

Answer for the CreditCards.com expert

Dear M.S.,
You do have a significant amount of debt, which makes your consideration of bankruptcy understandable. Bankruptcy exists in this country for good reasons, but should always be entered into with care. Your concern about your credit rating is also understandable. Bankruptcy can have a devastating, long-lasting effect on your credit score. Sometimes, however, there are no better options.

However, you do sound optimistic about your personal injury case. I agree with your attorney's advice to wait to decide about filing for bankruptcy. If you win your case, you will have some decisions to make. Much will depend on the actual amount of your settlement.

If you do indeed receive a substantial settlement, the bankruptcy option may be off the table. The question then would be if you should pay off your debts in full or offer a settlement to your creditors. At that point, you would probably have the cash available to negotiate settlements on your own. This is often the best option when it comes to settling a debt.

If you decide to try negotiating with your creditors for a settlement, be sure you get the terms in writing before you send any money. However, settling your debts will also have a negative effect on your credit score. In addition to the hit to your score, you could also face tax consequences. This is because any forgiven debt may be considered taxable income to you. Creditors that forgive $600 or more in debt must report that act to the Internal Revenue Service and to you, via Form 1099-C. What that means is that you would have to report the forgiven amount to the IRS and pay taxes on that amount.

The best thing you can do to restore your credit more quickly is to pay off your debt in full. I must caution you that this won't happen overnight. It will take some time for your credit score to recover. You will need to proceed cautiously when seeking and using new credit. In particular, if you get new credit cards, keep your credit utilization as low as possible and try to pay the balance in full every month on time.

Be wise with your credit!

See related: Debt settlement versus bankruptcy: which is more damaging to credit score?

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Updated: 01-23-2018