Does Debt Forgiveness Hurt My Credit Score?

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If you're really struggling to keep up with payments, debt forgiveness can seem like a godsend. The lender erases some of your debt to avoid you defaulting on the whole amount. Unfortunately, debt forgiveness has its downsides. One of these is that it will hurt your credit score. Another is that you will have to pay tax on the amount that is forgiven.

Debt Forgiveness

Debt forgiveness doesn't happen overnight. It's a result of a lengthy negotiation process with your creditor. In theory, you can do it yourself, but most people go through a company that specializes in negotiating with lenders. Banks are in the business of making money. They are not inclined to forgive debt out of the goodness of their hearts. The only reason they will do it is if they think there is a risk that you will default on your debt. To be eligible for debt forgiveness, you would need to show that you will never have the money to pay the debt in full, but that you can pay part of it. The bank will accept a partial payment and forgive the rest.

Debt Forgiveness and Your Credit Score

Your credit report contains a list of all of your debts and your repayment history. When a lender forgives part of a debt, they report it to the credit bureaus. It ends up on your credit report, where it stays for seven years, harming your credit score. It's impossible to say how many points you will lose—that depends on your personal financial circumstances—but it's likely to be more than 100. As years pass, the impact will subside.

Debt Forgiveness and Tax

The IRS considers forgiven debt the same as income. It's important to remember this when choosing between debt forgiveness and other debt solutions. You will have to pay income tax on the amount that is forgiven. If you can't pay it, the unpaid taxes will count as tax debt. The last thing you want to do is accrue more debt, and the government isn't in the habit of forgiving. When you calculate how much of your debt you can afford to pay, remember to include the tax liability in the calculation.

The Bottom Line

If you're drowning in debt, chances are that your credit score is less-than-healthy. And if you're really struggling financially, your credit score is probably not a top priority. A low credit score is not forever. Debt forgiveness will stay on your credit report for seven years. After that, it will be erased. In the meantime, you can take advantage of the clean slate and start rebuilding your credit history. Bankruptcy would be more damaging and would stay on your credit report for 10 years.