Cancellation of debt: What it is and why you should think twice about it

Who wouldn’t want their debt canceled?

As debilitating monthly payments stack up, the idea of wiping them clean in one fell swoop can’t get any more tempting.

While it may sound like an obvious solution to your debt troubles, it’s now without a cost.

So, what’s the catch? What does the cancelation of debt entail? What do you need to know before considering debt cancellation, and what are its consequences?

Read on to find out.

What is a cancellation of debt?

Debt cancellation is when a debtor's liability is forgiven or written off by the creditor. This means the debtor is no longer obligated to pay the balance.

Of course, that doesn’t come without consequences.

• Tax implications: The IRS may consider the canceled portion of the debt taxable income. For example, if $25,000 in debt was wiped out, it’s effectively the same as adding the amount to your taxable income for the year.
• Credit score harm: Debt cancellation can negatively impact your credit score. A record of the cancellation may stay on a debtor’s credit report for several years. This blight will serve as a red flag for future potential lenders.
• Borrowing limitations: Expanding from the previous point, cancellation can harm your chances of obtaining credit in the future. It may place you in a higher-risk category. This means the lender believes you are more likely to default on payments.
• Legal consequences: There may be associated legal costs if the cancellation occurs via bankruptcy.

Debt cancellation vs. other debt reduction strategies

Like debt cancellation, settlement and consolidation are debt reduction strategies. However, they differ from cancellations in several ways.

• Debt settlement is when a creditor agrees to a lump-sum payment lower than the total amount owed. Creditors typically accept this arrangement if they think it’s the best outcome they’ll receive. They take a reduced amount if they believe the debtor cannot fulfill the original amount. It’s important to note that the settled portion is sometimes called “canceled” debt.
• Debt consolidation is when an entirely new loan is taken out, and the proceeds are used to cover existing debts. Usually, a debtor pursues this option if they can obtain a lower interest rate. Consolidation also helps simplify debt management by reducing payments to a single obligation.

Debt cancellation pros and cons

Debt cancellation’s impact on credit

Debt cancellation’s impact on your credit depends on several factors:

• The reason for the cancelation.
• The way the cancelation is reported to credit bureaus.
• The debtor’s overall credit profile.

Here are some details to consider:

• Cancellation due to settlement: Negotiating with a creditor to pay a reduced amount might result in the account being labeled as “settled” instead of “paid in full.” While it confirms that you no longer owe the debt, the “settled” label tells future creditors you did not pay the entire original amount. As a result, it can harm your chances of obtaining additional loans.
• Cancellation due to bankruptcy: If a debt is cleared due to bankruptcy, it will typically be labeled as “included in bankruptcy” on your credit report. This is viewed unfavorably by potential creditors - even more so than a settlement. While its impact will lessen over time, it can remain on your credit report for seven to 10 years.
• Forgiveness program: Sometimes, debtors have outstanding balances forgiven. For example, the Public Service Loan Forgiveness program can clear eligible federal student loans. The impact on your credit score depends on how the forgiveness is recorded. Forgiveness may have no effect if reported positively (i.e., “paid in full”). However, if you missed payments leading up to the forgiveness, those events may still be recorded.
• Credit utilization: Cancelling debt may impact your credit utilization ratio and, ultimately, your score. For example, if the cancelation results in a closed credit card, your credit utilization may drop. This is the amount of credit you use relative to your available limit. All else equal, lenders prefer borrowers that have a lower ratio.

The value of a specialist

Debt cancelation is not necessarily a straightforward process.

At a high level, it’s a simple concept. In practice, however, some complexities and considerations warrant seeking professional guidance.

• Tax implications: Cancelled debt can have substantial tax implications. It’s imperative to understand the consequences before proceeding.
• Legal consequences: There may be a legal component to canceling the debt. It’s best to seek professional legal help for guidance.
• Credit score impact: While it can relieve pressure, canceling debt can adversely impact your creditworthiness. It’s helpful to have an expert explain how yours might be affected.
• Negotiation: Better terms may be obtained using a professional experienced in debt negotiation.
• Financial planning: A financial advisor can help you prepare for life after cancellation. That is, they can help ensure you have a solid financial plan that won’t result in additional financial trouble.
• Stress-reduction: Knowing an expert is in your corner can provide peace of mind.

If you’re thinking about debt cancellation, consider discussing the strategy with any number of specialists:

• Credit counseling agencies
• Certified public accountants (CPAs)
• Tax attorneys
• Debt settlement companies
• Bankruptcy attorneys
• Financial advisors
• Consumer protection agencies

For the right person at the right time, debt cancellation can invaluable. Still, it’s not a decision that should be taken without seriously considering its consequences.

Whatever you decide, remember that debt cancellation isn’t a free lunch; it comes at a cost.