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Why You Shouldn't Make a Deal With Your Credit Card Issuer

Last Updated Jun 20, 2009 6:21 PM EDT

Earlier this week, The New York Times ran a surprising credit card story. Apparently, some banks are now willing to work with customers and settle delinquent accounts for substantially less than the balance owed on the cards. In some cases, folks who are behind on their payments are seeing thousands of dollars forgiven.

At first glance, this development sounds like a godsend for all those consumers who have either lost their jobs or watched their interest rates jump to astronomical levels and now find they can't afford to pay off their debt. But making a deal with your credit card company isn't for everyone. In fact, I think it's something most of us should avoid. Here's why:

  • First, understand that your credit score will take a severe hit if you enter into debt settlement. (This is industry jargon for when a credit card company agrees to let you pay off less than you owe on your account.) Your credit report will show a "charge-off" for the amount not paid and your score could drop 20 to 50 points or more, say Gerri Detweiler. co-author of Reduce Debt, Reduce Stress .
  • Once creditors see the "charge-off" on your credit report, warning bells will ring and they will likely raise the interest rates on any additional credit cards you hold. So now your other balances will be tougher to pay off.
  • As if that's not bad enough, the banks issuing your

    other cards may go a step further and either lower your credit limit or opt to close your other accounts entirely, warns Adam Levin. chairman of . This is really bad news since your credit score will take another hit if the amount you are allowed to charge decreases or the average age for your existing cards (or number of years your accounts are open ) shrinks, he says.

  • Finally, there are the tax ramifications. The IRS considers forgiven debt taxable income. That means you'll receive a 1099 if you settle a balance worth more than $600, says Detweiler. You could possibly avoid this if you can prove you're insolvent (or owe more than you own) at the time you make your deal with the credit card company. But you'll have to fill out some forms and illustrate your hardship. Needless to say, avoiding paying Uncle Sam isn't easy to do.
What should you do if you feel you can't afford to pay off your debt? Do call your bank. But rather than asking if you can settle the account, see if you can get a customer service supervisor to lower your interest rate to make your minimum payments smaller and more manageable until you get back on your feet.

Would you be willing to settle your credit card account for less than you owe? Or are you concerned about what it would do to your credit score? Please share your thoughts with me.

© 2009 CBS Interactive Inc. All Rights Reserved.

Category: Credit

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