When some people think about credit card debt forgiveness, it goes something like this: Your debt is erased, and you live happily ever after with no consequences. That would be amazing.
But the harsh truth lies somewhere short of "totally erased" and "no consequences." To be clear, credit card debt forgiveness does exist, and it's possible to settle your debt for less than what you owe. But to get it totally erased is rare, and it usually requires an extreme measure, such as bankruptcy.
Read on to learn everything you need to know about credit card debt forgiveness and what it means for your credit score and your wallet.
What Is Credit Card Debt Forgiveness?
The best way to explain this is with an example. Let's say you have a $14,000 credit card balance and you're six months behind on your payments. At this point, your credit card company has sold your debt to a collection agency, so that's whom you'd be negotiating with.
You reach an agreement with the debt collector to pay back $10,000 in a lump sum or in installments. The amount of debt forgiven in this case is $4,000. This doesn't mean you can forget about the forgiven debt, though. Unfortunately, you might have to pay taxes on it.
But there are some steps you can take to avoid having to deal with a debt collector. If you take action as quickly as possible, you have an opportunity to talk to your credit card company before your debt is sold.
Act Quickly to Limit Damage to Your Credit
Ideally, if you're about to miss a payment on your credit card account, you'd call your credit card issuer before that happened. You'd ask to speak with the hardship department and explain your situation. But don't expect debt forgiveness at this stage.
"With a credit card issuer, you won't escape unscathed. You might get a 12-month reprieve from paying interest on the balance. But you're unlikely to get a reduced balance," says Gerri Detweiler, author of "Debt Collection Answers" and education director at Nav, a business credit and financing resource.
The advantage of catching this early is to get a little breathing room and minimize damage to your credit score. But the leniency usually only lasts 12 months.
So, you have to decide if a temporary solution will help you pay your debt. If it's the equivalent of throwing a glass of water on a forest fire, then you need a better solution.
Consider Talking to a Credit Counselor
If you decide a quick fix isn't in the cards, then it doesn't hurt to talk to a credit counseling agency and learn what your options are. Reach out to an agency accredited by the National Foundation for Credit Counseling. You can get a free phone consultation to understand your options. And seeking counseling, by the way, does not end up on your credit report and doesn't affect your score.
"The counselor can help you prevent damage to your credit report by establishing a budget and a plan to repay your debt that keeps the accounts current," says Thomas Nitzsche, media relations manager for Clearpoint, an NFCC-accredited agency.
With a debt management plan, you pay the full amount you owe over three to five years. But you might still get relief with a reduced interest rate, for example.
"Debt management plans are typically offered by nonprofit agencies such as ours and, in general, have fewer drawbacks. If the debt is still with the original creditor and the client can afford the plan, it's a less invasive method of debt relief than settlement or bankruptcy," says Nitzsche.
Negotiating With Debt Collectors
Maybe you decide to negotiate with a collection agency on your own. That could work, but you need to be careful about what you say when you talk to debt collectors. The Federal Trade Commission enforces the Fair Debt Collection Practices Act, which protects you from deceptive and unfair debt collection practices. You need to be aware of your rights so you can protect yourself.
Depending on your financial situation, you might be able to negotiate a lump-sum payment or make installment payments on a reduced amount.
Don't trust oral promises from a debt collector. Get your repayment plan in writing and don't make any payments before you do. This can be legally complex, so you might consider getting an attorney to help you get through this as smoothly as possible.
Beware of Debt Settlement Companies
Some of these companies will tell you to stop making payments, so you go into default on several accounts. At that point, they negotiate on your behalf. But by now, your credit score is in the trash heap.
These companies often engage in deceptive and unfair practices. Among other things, these companies might charge fees upfront, claim a new government program will wipe out your credit card debt and "guarantee" you'll get a huge amount of debt removed.
Some programs require you to deposit money in a savings account for 36 months or more. Many people have problems making the payments and drop out of the program. Be careful if you go this route. Check out the company you're considering with your state attorney general's office.
Potential Tax Consequences of Debt Relief
Remember our example with the $14,000 credit card debt balance and the $4,000 debt that was forgiven? For forgiven amounts that are greater than $600, the creditor has to send you an IRS Form 1099-C that shows the total amount forgiven.
Here's how to figure out if you owe taxes on that. You'll need to take a solvency test to determine if you were insolvent before you agreed to a $10,000 settlement. If the insolvency amount is less than the debt forgiven, then you owe taxes on the difference.
Let's keep it simple and say your total liabilities before the settlement were $14,000. And the fair market value of your assets equaled $12,000. In this case, you were insolvent by $2,000.
But this is less than the forgiven amount, which is $4,000. In this example, you'd have to pay taxes on the $2,000 difference. The income tax reporting on such matters can get complicated, so you might want to consult a tax attorney for assistance.
Bankruptcy Might Be a Better Option
Sometimes, you'd be better off declaring either a Chapter 7 or Chapter 13 bankruptcy than going for a debt settlement that requires installment payments that you can't manage.
"People tend to wait too long to speak to an attorney. Watch out for red flags that signal you need to take preventive action, such as liquidating a 401(k) [which is exempt from bankruptcy] to pay off credit cards, using payday loans and car title loans," says John Colwell, president of the National Association of Consumer Bankruptcy Attorneys.
Don't wait until you're on the brink of financial disaster. Make an appointment with a bankruptcy lawyer and review the pros and cons.
"More often than not, a bankruptcy attorney will give you a free consultation to see if bankruptcy is the right move," says Colwell.
How Credit Card Debt Forgiveness Affects Your Credit
A debt collection account stays on your credit report for seven years starting from the date of delinquency. To make it worse, the credit card company that sold your debt to the agency might also be reporting your account as charged off.
Clearly, all this messes up your credit score. But when you're in debt, you have to pick an option that not only stops the bleeding, but also gets you back on your feet.
There really is no such thing as a free lunch when it comes to credit. But take comfort knowing that your score will start getting better way before the seven-year period expires. "The credit score is most concerned about the past 24 months. You can start rebuilding your credit without all the debt," says Detweiler.
More From US News & World Report