We all need forgiveness sometimes, but when it comes to getting rid of debts, forgiveness can be more expensive than the original debt obligation.
If you are struggling to keep up with payments, bear in mind that there can be significant costs to simply having your debts wiped out, as appealing as debt forgiveness may seem. Before you choose to go that route, make sure you understand the consequences and have considered possible alternatives.
Debt Forgiveness - What Is It?
There are a variety of techniques for making debt more manageable, but forgiveness occurs when a debtor and creditor agree that the creditor will no longer be liable for some or all of what they owe that debtor. Of course, creditors don't grant this forgiveness lightly, so you would normally have to demonstrate both an insufficient income to make ongoing payments towards your debt, and a lack of assets to sell off towards paying your debts.
When it comes to forgiveness, student loans are a little more generous. Government-backed student loans - which are the vast majority of such loans - come with provisions that can limit the percentage of your income you are required to pay each year, and will eventually forgive part of your debt if you cannot pay it off within 20 years.
Normally, though, having debt forgiven must be negotiated with individual creditors. This is not an easy process - after all, financial companies do not make money by being forgiving. It can also be especially complicated if you are facing multiple creditors.
Further muddying the waters is that fact that debt forgiveness is also a big-money industry and one that is riddled with services that exploit struggling consumers or are outright scams.
What are the Side Effects?
Okay, so maybe the process of having debts forgiven is not always completely straightforward, but isn't it worth it to be able to walk away from what you owe? The truth is, it is hard to walk away totally free and clear. Think of loan forgiveness as a cure with potential side effects. Some of these can be the following:
- Tax consequences. In most cases, if a creditor forgives your debt, it's as if that creditor is giving you money - and that generally counts as income for tax purposes. So, you may free yourself of a creditor only to find yourself owing money to the IRS.
- Extra years of interest. Often, the process of trying to become eligible for debt forgiveness involves stopping or limiting payments on your debt. This could mean incurring interest charges over a longer time, so you would pay more interest on the portion of your debt that is not forgiven.
- Costly fees. Be especially wary of debt management services that charge you heavy upfront fees to negotiate with creditors on your behalf. Even services that don't charge upfront may claim a portion of the debt they manage to get forgiven. This means you get the tax bill while the company running the program pockets the money. Look for a not-for-profit credit counselor to help you get a handle on your debts.
- Potential of landing deeper in debt. Companies that negotiate on your behalf may not have as much influence on creditors as they claim. The process could cost you in the form of fees and interest charges, only for you to find out in the end that your representative was not successful in negotiating the forgiveness of your debt.
- Credit history impact. If a creditor does write off a portion of your debt, it will be reported to the major credit bureaus. This will have a lasting impact on your credit history that is likely to make it more expensive if not impossible to get credit in the future.
- Time-consuming paperwork. Whether it is student loan forbearance programs or getting creditors to write off debt, expect to put in some time filling out forms to become eligible for this special treatment. Most of all, be sure you receive and retain written confirmation that your debt has actually been forgiven, and not simply delayed.
Ever see one of those pharmaceutical commercials and conclude that the side effects they list sound nastier than the actual illness the drug addresses? Many consumers end up feeling the same way after they've had debts forgiven.
What are Some Alternatives?
Debt forgiveness might be the right approach in some situations, but only after a number of other alternatives have been exhausted - and you do have alternatives. Here are some possibilities to explore if you are struggling with debt:
- Lower-rate refinancing. A drop in interest rates following the housing crisis helped bail millions of homeowners out of burdensome mortgages. If conditions allow, refinancing at a lower interest rate is the best way to make debt less burdensome without negative side effects.
- Debt reorganization. If you have multiple creditors, simply consolidating debt into one source can make it easier to stay on top of your payments. This might also save you money on some higher-interest debt.
- Loan restructuring. Working with your creditor to stretch your loan payments out over a longer period can make them fit more readily into your monthly budget, though this is likely to cost you more in interest charges over the long run.
- Tax payment installment plans. If you owe more money to the IRS than you can pay right now, contact them about setting up an installment plan to help break that debt into manageable pieces.
- Tap into home equity. If you have built up equity in your home, borrowing against that equity can be one way to both consolidate multiple debts and reduce interest rates. Just be sure your budget can keep up with the monthly payments before you put your home on the line by borrowing against it.
- Downsize your home. Rather than borrowing against home equity, you may prefer to cash it in by selling your home and moving to a more affordable residence.
- Sell off other assets. Debt problems are often about cash flow - you may be worth more than you owe on paper, but lack the liquidity to make immediate payments. While not always convenient, selling off other assets to pay down debts can be cheaper than incurring extra interest, fees, or credit history consequences by trying to renegotiate those debts.
- Extreme budgeting. Unfortunately for many, debt can be the result of unforeseen circumstances or lack of preparedness to handle emergencies. But for some debtors, problems are the result of unwise spending habits. For those who might have been too impulsive, it might be time to rein in your lifestyle. See if making deep cuts to expenses might allow you to keep up with your loan obligations.
- Bankruptcy. People think of bankruptcy as a last resort, but debt forgiveness can have some of the same negative consequences without providing as much protection from creditors as bankruptcy. If you have exhausted all the other possibilities, look into a Chapter 7 bankruptcy. Don't kid yourself - it won't give you a clean slate, but it will at least lay out a pathway towards getting better control of your finances in the future.
All of this takes some work, and it may seem tempting to try to convince creditors to write off a portion of your debts instead, but that process is not as easy as it sounds. In the long run, it may be simpler and cheaper to continue working to pay off debts than to have them forgiven.