Will a debt settlement adversely affect our credit rating?
We are drowning in debt--over $80,000 in
credit card debt, some at over 30 percent! We are taking a second mortgage out on our
house to pay it off. Should we ask the credit card companies to lower our payoff
amount for paying off the balance in cash? Will this adversely affect our credit
rating? Even a 10 percent reduction would pay for a car for my son. Your advice
Wow! That is a large amount of debt at a high rate!
Even if you can afford to repay the principal, the interest rates are
ridiculously high. At 30 percent, if you spent $2,100 per month paying down that
$80,000, it will still take more than 10 years to repay and cost a total of
$259,000 to pay off
Your plan to take a second mortgage on your home
to save money is a good one. Of course, there are potential risks and rewards. The
risks include the reality that you’re taking unsecured debt (the credit cards)
and repaying it by using your home as collateral. This is okay as long as you’re
not in any immediate financial trouble, like a job-loss situation.
The reward is that you will, or should, receive a
much lower interest rate on the second mortgage, and you will be able to deduct
the interest charges from your income for tax purposes. You can calculate your
comparable credit card rate (the rate a credit card would need to be in order to match
the second mortgage with taxes taken into account) by simply subtracting your
tax rate from one and multiplying this by the second mortgage rate. For example,
if you’re in the 15 percent tax bracket and your second mortgage rate is 7
percent, then your credit card rate would have to be 5.95 percent ([1-0.15] x 7)
to match the 7 percent second mortgage with all its tax benefits.
Of course, getting the banks to reduce your
outstanding balance would be nice. Then you wouldn’t have to refinance that
entire $80,000 with the second mortgage. It’s probably true that much of that
balance is from that rip-off 30 percent interest rate anyway! But, you do ask an
important question, specifically, “Will this adversely affect our credit
Yes, it could! That’s because the credit card bank
will report it as a settled account. And even further, you will receive a 1099,
which will require you to pay taxes on the amount you save.
So what do you do?
Well, I would attempt to settle the account for
less and make it part of the negotiation that the account is reported “paid as
agreed.” Although, this may be a difficult condition to get the banks to agree
to. Additionally, if you’ve been paying them on time, never been late, or even
pretty good with your payments, the banks will probably not even negotiate with
you for any reduction because—why should they? You’re paying them back, so why
settle for less. And, with the new changes in the bankruptcy law in effect, the
banks are even in a better position to be tough.
Still, you should look into all your options. Give
the bank a call and see what they can do. If you can settle for less without it
affecting your credit history, then I would do that. But just be sure to get
everything in writing before you send them the check! It’s been my experience
that once you pay, they forget the terms of settlement.