As per research, around 1.2 million debt accounts were settled in the US in the year 2022. That makes around $2.8 billion of forgiven debt. Debt settlement is undeniably one of the most popular and commonly used debt relief options especially because it reduces the debt amount and provides the kind of relief borrowers are in dire need of. From credit balances to personal loans and medical bills, there’s a significant number of people stuck with debt and financial crisis at the same time. Getting a loan approved sounds really exciting and it sorts out the financial troubles for people in the moment. However, the trouble begins when there are monthly repayments with interest, this is where people usually get stuck especially if they don’t have a reliable source of income.
During such situations, you can’t just ignore your monthly payments and let your debt pile up. Late or delayed payments can wreak havoc on your credit and it can increase the overall cost of your debt too. In simpler words, if you aren’t able to pay off your debt then it’s best that you take timely action or else it’ll lead to more grave financial issues and sometimes legal actions too.
What Is Debt Settlement?
Debt settlement is a negotiation between a borrower and a creditor where the borrower pays a lump sum of the total debt and in exchange, the lender forgives the rest of the outstanding balance. In simpler words, debt settlement can help reduce the total amount you owe but the process isn’t as simple as it seems.
Your creditor is absolutely under no obligation to accept your settlement offer. He can reject your offer and some might even take a legal action against you. This is what makes the process a little tricky. You have to use a very professional approach for a successful settlement and on top of that, it’s important that you really are facing a serious financial hardship that’s making it impossible for you to manage your monthly repayments. If you have a valid reason with proof then yes, chances are that your creditor will agree to your terms and waive off some of the portion of your loan.
Is Debt Settlement Legal?
Fortunately, yes, debt settlement is a completely legal process. There are no laws in any country that prohibit borrowers from negotiating a lower payoff with their creditors. However, the legality does come with a few conditions. The act of settlement is legal but the way it’s done is something you have to be careful about. Especially if you are involving a third party in the matter then you have to ensure that their methods comply with the state and federal laws.
Key Laws Regarding Debt Settlement In The US
To protect yourself from any legal trouble, it’s important that you first understand the in and out of the settlement process. Here are some important laws and regulations when it comes to practicing debt settlement in the US;
1-The Telemarketing Sales Rule (TSR) – Federal Trade Commission (FTC)
FTC plays a very important role when it comes to the regulation of debt settlement companies, especially the ones using telemarketing to approach their customers. The key provisions of the TSR include;
- No settlement company can charge any fee until the debt has been settled or negotiated. If any agency or professional asks for a fee before the process, no consumer should work with it.
- Before charging any fee, the company has to provide proper documentation regarding the settlement terms and debt reduction.
- Consumers are supposed to have a separate FDIC insured bank account from which they have to make the payments to the creditor.
- Before any consumer signs any contract, settlement companies have to disclose all the details of the settlement and its consequences in detail. In simpler words, there has to be complete transparency in the debt settlement process.
2-Consumer Financial Protection Bureau (CFPB)
The CFPB is specifically for financial products and services of consumers and it includes debt relief programs. It’s their utmost duty to ensure compliance with consumer protection laws and they have to investigate any unfair or deceptive practices of settlement companies. Consumers can easily file a complaint with the CFPB, which will then investigate the matter and take the required actions accordingly.
3- Internal Revenue Services (IRS)-Tax Implications
The IRS isn’t linked with the regulation of debt settlement but yes, it does affect the final outcome of the settlement. For example, if your creditor has forgiven more than $600 of debt then you have to pay income tax on the amount. The creditor will provide you and the IRS the 1099-C form which means that your forgiven amount is taxable. The only exception is that if you were insolvent at the time of settlement then the IRS won’t tax you but you’ll have to show proof of insolvency first.
4-State Laws
Most states out there come with additional regulations like licensing requirements and fee caps. Before you hire any debt settlement company, it’s important that you first check with the state laws. For example, in Illinois and California, debt settlement companies must be licensed and they must adhere to the fee limits.
Risks And Legal Considerations In A Debt Settlement
Just like any other debt relief option, debt settlement comes with its own risks and legal consequences which is why it’s very important that you study them first.
1-Impact On Credit Score
Debt settlement will bring your credit score down and this damage cannot be avoided. Your “Settled” account will stay on your credit report for 7 years and all of this means that in the future, lenders might hesitate a little when giving you a new loan. Even if you get a new loan, you’ll have to pay a much higher interest on it. Moreover, with a poor credit score, you’ll face issues with getting credit cards, mortgages and sometimes employment too.
2-Tax Implications
As said earlier, the IRS considers any amount exceeding $600 forgiven by your creditor as taxable. You’ll be given a 1099-C Form which means that you are obliged to pay your income tax on it and the only way out is if you qualify for insolvency or bankruptcy. Most people aren’t aware of the tax consequences of debt settlement and then they end up in deeper trouble when they receive the tax bill. To avoid such issues, it’s best to work with a financial attorney.
3-Success Isn’t Guaranteed
Whether you talk to your creditor directly about a debt settlement or hire a proper company, you must know that success is never guaranteed. Your creditor is under no legal obligation to accept your settlement offer and in some cases, they even take legal action against the borrower. In a nutshell, it’s a risky process so you have to take the right path forward for a successful negotiation.
4-Risk Of Lawsuits
If you stop making your payments during the settlement, you might end up getting a lawsuit by your creditor. This is quite common for lenders to sue the borrowers for non payments. In such a situation, you might face wage garnishment, additional legal fees and even bank account levies. Even if you successfully avoid a lawsuit, the threat of legal action will keep looming over you until the debt is officially settled.
Final Thoughts
Debt settlement is legal and if you take the right path forward, it can help you regain control of your finances. However, it comes with its own consequences and you must be prepared for all scenarios before starting the negotiation. It’s important that you first understand your rights, properly research the laws of your state and then work with a professional or a reputable debt settlement company for the best outcome.
FAQs
Q1. Is Debt Settlement Legal In All States?
Yes, debt settlement is very much legal in all the states of the US. However, every state comes with its own laws and ways to regulate the process along with the debt settlement companies. For example, some states require debt settlement companies to be licensed and some require a limit fee. It’s best if you first check your state specific laws before starting the process.
Q2. Can A Creditor Refuse To Settle My Debt?
Yes, no creditor is under any obligation to accept your settlement offer. Creditors can reject your offer, charge higher interests and fees and some might even take legal action against you to recover their loan amount in full.
Q3.How Long Does The Debt Settlement Process Take?
Depending on the number of debts, the total amount and your creditors, debt settlement can take anywhere between 3 months to 3 years. It also depends on how quickly you are able to save up for the lump sum payment.