True forgiveness of credit card debt is pretty much a myth. But some level of debt obligation reduction happens frequently via credit counseling, debt settlement and even bankruptcy. Let’s explore what they will do for your debt and your credit score.
What do we really know about forgiveness?
We’ve all heard phrases like forgive and forget, forgive us our trespasses, to err is human – to forgive divine!
But in the real context of contracts, debts and credit, is there truly forgiveness to be had?
In the world of debt forgiveness, it’s important to know that true forgiveness of credit card debt is pretty much a myth. My experience has been that credit card debt forgiveness, unlike student loan or mortgage deficiency forgiveness, comes with a lot of strings and is anything but a free lunch.
That being said, some level of debt obligation reduction happens quite frequently through channels like credit counseling, debt settlement and even bankruptcy. Let’s explore what each of those entails and what it will do to and for you, your credit card debt and your credit score.
Bankruptcy exacts the harshest price on your credit. It should be the last of your options when it comes to dealing with overwhelming debt, including credit card debt.
As a rule of thumb, the higher your score going into a bankruptcy, the more points you lose. So, if you are at 760 before, don’t be surprised if you experience a 200-point drop.
It is true that if you qualify for a chapter 7 bankruptcy filing, any credit card debt you owe will be effectively wiped out and you can get a fresh start. This is what I call the “silver lining” of filing for bankruptcy in my book “Credit Repair Kit for Dummies.” In addition, you will receive free credit education, which will help you see how you got to this point and (hopefully) avoid those pitfalls in the future.
It’s important to note that not all of your debts can be erased even in a chapter 7 filing; taxes, child support and student loans are among the debts that will not be erased. But since we are talking mainly here about credit card debt, that would go away.
This is only true for a chapter 7 filing, which requires a means test to determine your eligibility. This is to see if you truly cannot afford to pay even a part of your bills. If you cannot pass this means test, you are likely looking at a chapter 13 filing.
Here you will be required to make payments toward your debt, and although these payments will likely be reduced, they will eat up a significant portion of your income. Also note that debts discharged in bankruptcy – either chapter 7 or chapter 13 – are not subject to income tax because they are liquidated and not forgiven, so that is one less small worry.
While bankruptcy exists in this country for very good reasons, it is going to seriously damage your credit score, remaining on your credit report for up to 10 long years. Think long and hard before you take the bankruptcy plunge to rid yourself of credit card debt.
See related: What can I do if bankruptcy is not an option?
The idea of paying only a fraction of what you owe is certainly appealing if you are struggling.
Debt settlement should also be entered into very cautiously, although the length of time it will impact your credit report is seven years, not 10. So, that’s a small plus. But the damage to your score will be substantial. Should a creditor decide to settle a debt for less than you owe, the balance forgiven will be charged off and your credit report will show a “debt settled” notation.
I strongly suggest you negotiate your settlements yourself or with the help of a trusted attorney and stay away from those companies that promise to rid you of your debt for “pennies on the dollar.” Anything those companies can legally do, you can do yourself without having to pay a fee for their services.
I also suggest you try to work with the original creditor if you can. This is not always possible, but it is always worth a shot.
Lastly, if you are successful in having some of your debt forgiven, be aware that any forgiveness flows from your creditor and not from the IRS, who will treat any forgiven amounts larger than $600 as taxable income.
Debt management plan
Nonprofit credit counseling is often the best choice when it comes to dealing with overwhelming credit card debt.
These are the good guys who have established relationships with most major creditors and have already done the work of negotiating deals that will get you out of debt in five years or less. Commonly known as debt management plans (DMP), this is credit counseling’s systematic approach to ridding you of your credit card debt.
And, just like bankruptcy, this approach also offers invaluable credit education to help you avoid future problems (without the nasty side effects of bankruptcy).
So, what’s the damage to your credit score in this scenario? Being on a DMP in and of itself is considered neutral in the scoring world. What will hurt you is the closing of your credit accounts, which is a DMP requirement. This is because of the loss of available credit in your credit score equation.
However, if you are at the point where you have considered debt settlement or even bankruptcy, it is likely that the damage to your score has already been done or is unavoidable.
Potential savings from a DMP
Now you may be asking, “where’s the debt forgiveness if I enroll in a DMP?” While your principal balances are not reduced, what will be reduced is the amount of interest you will be paying back and any late or over limit fees.
Depending on your current interest rates, this could amount to a serious chunk of change. (As a side note, these savings are not subject to tax, which is welcome news.)
For instance, if you have $20,000 in credit card debt with an interest rate of 22% you are looking at a monthly payment of $552 (plus possible over-limit and late payment fees) to pay off the debt in about five years. Remember, this means you will not be adding to your balances and your payment will stay the same each month.
By working with a non-profit credit counseling agency, many creditors will significantly reduce the account interest rate and waive over-limit and late fees. Dropping the interest rate to 6%, for instance, would reduce your monthly payment to $386. That’s a difference of $166 a month, which equals $9,943 saved over that five-year period.
That might not be true debt forgiveness, but it is true savings. Also remember that this is just an example; if your interest rates are higher or you can get an even lower interest rate, you will realize larger savings. You can find one of the good guys of credit counseling at the National Foundation for Credit Counseling.
See related: How to lower your credit card interest rate
Finally, as I’ve said over and over again, making on-time payments is the best thing you can do for your credit score. Abiding by a DMP agreement to climb out of your credit card debt will enable your credit score to show marked improvement over time. And the good news is that it should not take the whole five years to see that improvement.
Remember to keep track of your score!