Cancelling or Forgiving Debts: Options Under Debt Settlement and Bankruptcy

In today’s saturated financial market, the promise of debt cancellation lures in individuals grappling with insurmountable debt. Amidst the clamor of advertisements from debt settlement companies like National Debt Relief or Freedom Debt Relief promising to reduce or cancel debts, understanding the nuances of debt settlement versus bankruptcy becomes paramount.

Many advertisements will talk about your rights to settle debts or state the the law authorizes a program to cancel your debts or pay less than the amount that is owed. However, there is no specific program or law; usually these companies are talking about the possibility of debt settlement. Debt settlement is basically the re-negotiation of terms directly with the creditors. While sounds like a great option, when actually reviewing the mechanisms of debt settlement, it is a lot more complicated process than it is initially advertised. There is no guarantee in these settlement processes and, in reality, the only legal process that cancel is bankruptcy.

Understanding Debt Settlement

Debt settlement, often heralded as a beacon of hope for those drowning in debt, operates on a simple premise: negotiating with creditors to settle debts for less than the full amount owed. Here’s a detailed breakdown of the process:

  1. Initial Assessment: Upon enlisting the services of a debt settlement company, individuals undergo a thorough financial assessment. This evaluation scrutinizes income, expenses, assets, and debts to determine eligibility for the debt settlement program. After reviewing the situation, the debt settlement company advises debtors to stop paying debts and make payments to the debt settlement companies instead.
  2. Payment Plans and Escrow Funds: Debt settlement companies devise payment plans tailored to individual’s liabilities. Clients make monthly payments into a dedicated escrow account established by the company. These funds accrue over time, forming the basis for settlement offers to creditors.
  3. Negotiation Process: Armed with a pool of accumulated funds, debt settlement companies commence negotiations with creditors on behalf of their clients. These negotiations aim to secure favorable settlement terms, typically involving a lump-sum payment lower than the original debt amount.
  4. Settlement Resolution: Upon reaching an agreement with creditors, funds from the escrow account are disbursed to settle the debt. Creditors may agree to forgive a portion of the debt in exchange for the agreed-upon settlement amount.

While debt settlement offers a potential pathway to debt relief, it’s essential to consider the associated costs and timeline:

  • Fees: Debt settlement companies typically charge fees ranging from 15% to 25% of the original debt amount. These fees are often deducted from the accumulated funds in the escrow account, reducing the amount available for settlement.
  • Timeline: The duration of the debt settlement process varies depending on factors such as the amount of debt, creditor cooperation, and the client’s ability to make consistent payments. On average, debt settlement programs may span two to four years. Initial estimates on any settlement plan are usually shorter than the actual process since settlements can be delayed when creditors refuse to accept offers, require a higher than estimated settlement amount, or proceed with lawsuit or other collection activity.
  • Impact on Taxes: There can be taxable income after any settlement. Forgiven debts exceeding $600 are typically reported to the IRS and may be considered taxable income. Individuals should consult with a tax advisor to assess the potential tax consequences of debt settlement.

Example Scenario — While debt relief companies can promise to settle your debt for less or cancel a percentage of your debts, it is important to consider the total out of pocket costs. A debt settled for 60% of the total debt will not result in a 40% savings overall.

  • Original Debt Amount: $20,000
  • Settlement Amount: After negotiations, creditors agree to accept $12,000 as full settlement of the debt.
  • Debt Settlement Company Fees: Assuming a fee of 20%, the company charges $4,000.
  • Tax Consequences: The forgiven debt of $8,000 ($20,000 – $12,000) may be considered taxable income, potentially leading to additional tax liabilities for the individual. If someone is in a low tax bracket (say 12%), then they would pay an additional $960 in taxes.
  • Out of pocket costs: $16,960 (savings of $3,040) — while still a savings over what was originally owed, the result is still paying 85% of the total debt, or a savings of 15%.

Additionally, the road to debt settlement is fraught with risks:

  • No Guarantees: There’s no assurance that creditors will agree to settle, leaving individuals in a precarious financial position. Without a settlement, a creditor will usually proceed with legal action, like a lawsuit. Additionally, if a creditor agrees to settle only at a higher amount than budgeted, this can result in needing to find additional funds.
  • Damage to Credit Score: Delinquent payments and settlements can severely damage credit scores, making it challenging to secure future loans or lines of credit. Credit scores take a huge hit after anyone stops paying on their debts. There is improvement after accounts start settling, but that is usually 12 to 36 months after entering into the payment plans.
  • Tax Implications: Forgiven debts may be considered taxable income, leading to unexpected tax liabilities.

Bankruptcy: The Legal Route to Cancel Debt

Contrary to popular belief, the only legal process for debt cancellation is bankruptcy. The two most common options are:

Chapter 7 Bankruptcy (aka Liquidation Bankruptcy):

Chapter 13 Bankruptcy (aka Wage Earner Plan/Payment Plan Bankruptcy):

  • Repayment Plan: Chapter 13 involves creating a repayment plan, allowing individuals to retain assets while gradually paying off debts over three to five years. As a result, no risk to losing any property, including your house.
  • Debt Adjustment: Some debts may be partially discharged or restructured under the court-approved repayment plan.
  • Protection from Foreclosure: Chapter 13 can halt foreclosure proceedings, providing an opportunity to catch up on missed mortgage payments.

Since bankruptcy manages all debts through a structure process, credit rebuilding happens immediately. Most people after a Chapter 7 have credit around 600 to 620, while people after a Chapter 13 have credit around 630 to 650. Your credit also can improve steadily after bankruptcy because little to no debt will be reporting. This is different than debt settlements when each account is being dealt with individually.

While debt settlement may offer a glimmer of hope for individuals grappling with overwhelming debt, it’s essential to approach it with caution. A process that cancels debts may seem like a blessing, but understanding the intricacies of the debt settlement process and debt relief options in general, including payment plans, fees, and tax implications, is paramount for making informed financial decisions. Moreover, comparing debt settlement with the legal recourse of bankruptcy, whether through Chapter 7 or Chapter 13, provides a comprehensive perspective on debt management strategies. Seeking guidance from a qualified bankruptcy attorney can offer invaluable insights tailored to individual circumstances, paving the way for a brighter financial future and an option to possible get debts forgiven or cancelled//

Attorney Ashley F. Morgan, a Virginia licensed attorney that focuses on debt relief, especially bankruptcy issues, regularly helps clients deal with debts. During her consultations, she discusses all available options, including debt settlement and bankruptcy. If you are a Virginia resident and are considering any debt cancellation program, feel free to schedule a free consultation with our office. She has help thousands of people cancel debts.