Debt Consolidation

Understanding Debt Forgiveness

Debt Forgiveness

If you’re struggling with debt and can’t see a feasible way out, it’s only reasonable to wonder if some of your debt could be forgiven. By accessing debt forgiveness programs, you could potentially get out from under your costly financial mistakes and score the clean slate you’ve always wanted.

The good news about debt forgiveness programs is that they absolutely exist for credit card debt, mortgages, tax debt and student loans. Unfortunately, debt forgiveness programs aren’t perfect, as each comes with a range of stipulations and pitfalls to be aware of.

This guide aims to demystify the various types of debt forgiveness available so you can make an informed decision on how to handle your debt.

Credit card debt forgiveness

Mortgage forgiveness

Student debt forgiveness

Tax debt forgiveness

What are the side effects of debt forgiveness programs?

Alternatives to debt forgiveness

Credit card debt forgiveness

Many families struggle with unruly credit card bills. Fortunately, there are a few ways to escape credit card debt – or at least settle for less than what you owe.

According to Thomas Nitzsche, spokesperson for Money Management International, the largest nonprofit credit counseling agency in the U.S., there are three main types of debt forgiveness that can be applied to credit card debt – debt settlement programs, bankruptcy and negotiating your debts directly with creditors.

How debt settlement programs work

Debt settlement companies are typically for-profit entities that work with you to negotiate down the debts you owe. Typically, they ask you to stop paying your bills and instead start saving up a lump sum you can use to “settle” your debts with cash. These programs usually require you to transfer your new savings to a jointly-held escrow-like account so they can handle and settle your debts for you.

What to watch out for

While debt settlement can help you pay less than what you owe on your credit cards, there are risks to watch out for. As the Federal Trade Commission (FTC) notes, your creditors aren’t obligated to settle your debts. Not only that, but debt settlement companies typically require you to stop paying your credit card bills as you gear up to settle — a move that will cause your credit score to take a big hit.

Nitzsche also says that some of these firms charge large fees for their services, and those fees can make it harder to save and pay down some parts of what you owe. Lastly, there may be tax consequences if you have debts forgiven, even if debt settlement companies don’t tell you about them. Nitzsche says that you’ll receive a 1099-C in the mail for forgiven debts over $600, and you’ll need to pay income taxes on those amounts.

How bankruptcy works

Bankruptcy is a formal process that may allow you to forgo paying back some of your credit card debt. Nitzsche points to two different types of bankruptcy that could be applicable here – Chapter 7 and Chapter 13. Under Chapter 7 bankruptcy, it’s possible debts would be forgiven entirely, he says. In the case of a Chapter 13 bankruptcy, however, you would need to repay your debt but have some level of forgiveness.

What to watch out for

Nitzsche notes that both types of bankruptcy will have adverse effects on your credit score – and the effects can be long-lasting. The FTC says that credit reporting agencies can report negative information for seven years and bankruptcy information for 10 years. Also, bankruptcy isn’t free, as you’ll need to pay legal and attorney fees for your bankruptcy to process. The FTC even says that filing fees for both types of bankruptcy can cost “several hundred dollars” on their own.

How negotiating directly with creditors works

Nitzsche notes that it’s possible to negotiate paying less than what you owe on your credit cards without the help of a debt settlement agency, but that your card issuers may not consider this unless you can prove you’re experiencing some form of hardship. However, “the more common scenario is that your credit card debt goes to collections and you can offer them less than you owe,” he said. In this case, you would try to settle with the debt collections company instead of your credit card issuers.

What to watch out for

While doing your own negotiating may seem better than working with a debt settlement company, there are still pitfalls to watch out for. You typically need to pay a lump sum to settle your debts, says Nitzsche, and savings that much can be difficult to achieve if you’re struggling to pay bills already. You’ll also need to pay income taxes on forgiven debts of more than $600.

Mortgage forgiveness

Nitzsche notes that after the Great Recession that began in 2007, several mortgage forgiveness programs came to fruition. One was the Mortgage Forgiveness Debt Relief Act of 2007, which allowed consumers to exclude debt forgiven on their primary residence from 2007 to 2016. Another was the HARP program, which was created to help consumers with underwater mortgages refinance to get a lower interest rate and better loan terms.

Nitzsche says that today, the main paths to have mortgage debt forgiven include foreclosure and short sales.

How foreclosure works

Foreclosure takes place when you take out a mortgage to buy a home but cannot repay the loan. The lender can then foreclose on and take ownership of the house. Generally speaking, your home loan needs to be at least 90 days delinquent (unpaid) for a foreclosure to be considered. So yes, you may have your mortgage debt forgiven, but you will also lose your home.

What to watch out for

Nitzsche warns consumers that foreclosure doesn’t actually mean your loan goes away. Your lender still has the right to try to collect the balance of your home loan until you file bankruptcy and include your home in your bankruptcy proceedings. Another downside of foreclosure (and potential bankruptcy) is that it will damage your credit for years, says Nitzsche. Going through foreclosure will also make it harder to get a home loan for up to seven years.

How short sales work

A short sale takes place when you try to sell your home but you can’t get as much as you still owe. In this case, you can contact your lender and apply for a short sale. In this type of sale, your lender may agree to let you sell your house for less than what is owed and forgive the remaining balance.

What to watch out for

Nitzsche notes that a short sale will damage your credit score and may impede your ability to get a mortgage in the future. However, the damage won’t be as bad as filing for foreclosure. The FTC says that while foreclosure usually prevents people from getting a mortgage for seven years, individuals who go through a short sale may only need to wait two years to buy a home again.

Like many other types of forgiven debts, you’ll need to pay income taxes on the loan balances forgiven on your home provided the amount is over $600.

Student debt forgiveness

If you’re desperate to drop your student loans and are considering bankruptcy,  Adam S. Minsky, an attorney whose practice focuses solely on student loan debt, says that bankruptcy is not impossible for student loans, just unlikely. To qualify, you would have to prove “undue hardship” in court, and this is a very difficult standard to prove, he says. It also requires something called an “adversary proceeding” in bankruptcy court, which is an unlikely proposition. In almost every case, you won’t be able to discharge your student loans in bankruptcy, he says.

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Minsky also points out that when it comes to private student loan debt, it is almost never forgiven. “Options are often limited for borrowers struggling with their payments on private student loans,” he said. Borrowers can use a forbearance to temporarily postpone payments, although this will likely be for a very limited period of time. Private loan borrowers may also consider refinancing their loans if they could qualify for a lower interest rate and better loan terms.

Fortunately, there are many different types of student loan forgiveness, some handled on the federal level and others occupational in nature. Minsky says that the main types of student debt forgiveness to consider include Public Service Loan Forgiveness (PSLF), income-driven repayment plans and occupational forgiveness programs offered through various media.

How Public Service Loan Forgiveness (PSLF) works

To qualify for PSLF, borrowers need to make 120 qualifying payments on federal direct loans under an income-driven plan or the 10-year standard repayment plan while working full time in qualifying public service employment.

What to watch out for

While PSLF is a smart option for students willing to work in public service, it may not be around for long. The Trump administration has put forward new legislation that could end the program as we know it. Minsky also notes that it’s crucial to make sure you’re meeting program requirements to qualify for PSLF. If you don’t meet all requirements for the program and make sure you’re properly registered, it’s very likely your payments won’t count toward PSLF.

How income-driven repayment plans work

Income-driven repayment plans such as Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE), Income Contingent Repayment (ICR), and Income Based Repayment (IBR) let you pay a percentage of your discretionary income toward your student loans for 20 to 25 years. Once the program is completed, your remaining student loan balances will be forgiven provided you are still in compliance with the program.

What to watch out for

Like with PSLF, it’s crucial to make sure you are properly signed up for income-driven repayment for your payments to count. But, unlike PSLF, you would need to pay income taxes on forgiven amounts under income-driven repayment plans.

Of course, none of this could matter soon. Like PSLF, income-driven repayment plans could be axed if the Trump administration gets their way. Under the new legislation, any income-driven repayment plan that lets you make lower monthly payments would likely severely limit loan forgiveness.

How occupational loan forgiveness plans work

Minsky says there are many other types of loan forgiveness, and the specific requirements vary from program to program and based on your state and occupation. For example, there are Teacher Loan Forgiveness, Perkins Loan Forgiveness, and repayment assistance programs like the National Health Service Corps. Health care providers like nurses and doctors may also have loan forgiveness programs available based on their position and location.

“Borrowers should thoroughly research the programmatic requirements to see if they may qualify,” said Minsky.

What to watch out for

Like the other types of student forgiveness on this list, these programs often have strict requirements that must be met in order for you to qualify. You may need to commit to work in a specific job or a high-need area with many occupational forgiveness programs.

Tax debt forgiveness

The main program that allows individuals to have their tax debt forgiven or delayed is an Offer in Compromise. “An offer in compromise allows you to settle your tax debt for less than the full amount you owe,” as stated on the website. “It may be a legitimate option if you can’t pay your full tax liability, or doing so creates a financial hardship.”

Nitzsche also says that the IRS frequently lets people create payment plans for tax debts they owe. While these plans won’t let your debts be forgiven, they can allow you to make monthly payments until your tax debt is paid off.

How Offers in Compromise work

The IRS considers the following factors when determining eligibility for an Offer in Compromise:

  • Ability to pay
  • Income
  • Expenses
  • Asset equity

The agency typically approves offers “when the amount offered represents the most we can expect to collect within a reasonable period of time.” The IRS says that you can fill out the pre-qualification form to see if your debt may qualify for this option.

What to watch out for

The IRS states that your request for an Offer in Compromise may not be approved, but that you may be able to appeal within 30 days of receiving a rejection. Either way, you will need to come up with a lump sum of cash or a down payment followed by periodic payments to pay off your agreed debt settlement. Also, the IRS says that any refunds due to you within the year your Offer in Compromise is accepted will be withheld and applied to your tax debt. This means that, if you’re accustomed to seeing a big tax refund, you can expect it to disappear the year you settle your tax debt.

What are the side effects of debt forgiveness programs?

While debt forgiveness can give you the relief you’re looking for, that doesn’t mean programs that offer this option are trouble-free. In the real world, there may be consequences for having your debts forgiven, including:

    • Tax Consequences. Steven J. Weil, Ph.D., president of RMS Accounting, says it’s crucial to understand the tax consequences of forgiven debt. Generally speaking, you’ll need to pay income taxes on forgiven debts of $600 or more. As an example, let’s say you owe $10,000 in credit card debt and agree to settle for $5,000 cash. In this case, you would receive a 1099-C for the $5,000 in debt that was forgiven.
    • Costly fees. Nitzsche notes that many types of debt forgiveness can cause you to incur costly fees. Debt settlement programs tend to charge upfront fees or a monthly subscription, he says. Bankruptcy can also be expensive.
    • Potential for landing in deeper debt. As a credit counselor who works with clients struggling with debt regularly, Nitzsche warns that if you don’t change your spending habits, debt forgiveness may not leave you better off. To benefit from lower payments or a totally clean slate brought on by debt forgiveness, you need to learn to spend less than you earn and never borrow more than you can afford to pay back.
    • Credit history impact. Almost all types of debt forgiveness will cause a negative impact on your credit score, says Nitzsche. This includes bankruptcy, credit card debt forgiveness and short sales, for example. However, student loan forgiveness programs will not impact your credit negatively.

  • Time-consuming paperwork. Some of these programs take time to wade through, says Nitzsche. If you’re calling all your creditors to negotiate a settlement on your own, for example, this takes time. Signing up for debt forgiveness programs or a debt settlement company will also take time and fortitude.

Alternatives to debt forgiveness

If you think debt forgiveness could be the answer you’re looking for but also want to consider the alternatives, here are some of the other ways to handle certain debts that are overwhelming your finances:

  • Debt consolidation – “Taking out a new debt consolidation loan to pay off all your debts can be a smart idea,” said Nitzsche. Doing so will help you simplify since you’ll go from having multiple monthly payments to one. If you score a lower interest rate, you can also save money as you pay down debt.
  • Zero percent interest credit cards – If your goal is paying off credit card debt, a credit card with a 0% intro APR can help you stop paying interest and pay down debt faster. These cards typically offer a promotional 0% APR for six to 21 months, although some charge a balance transfer fee equal to 3 to 5 percent of your balance.
  • Refinancing. Refinancing your debt can also make sense, says Nitzsche. If you have equity in your home, for example, you could consider taking out a home equity loan or a personal loan and using it to pay off your debt. Just remember that, as of 2018 and as long as the new tax law stands, interest on home equity loans is no longer tax-deductible.
  • Extreme budgeting. Cutting your expenses is another strategy that can help you pay off debt. By spending less on bills and discretionary expenses, you can free up cash you can use to pay credit card bills and other outstanding debts.
  • Bankruptcy. Bankruptcy is another option to consider that could potentially wipe away all or some of the debts you owe. Just remember that there are consequences for filing for bankruptcy, including long-term damage to your credit score and the costs of filing.

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