Debt Forgiveness: The Pros and Cons

A man checks financial papers.

The decision whether to seek debt forgiveness can have serious consequences for taxes and credit standing. This article is not intended as legal advice for your specific circumstances and does not create an attorney-client relationship with Lexington Law.

Debt forgiveness is when part or all of the outstanding balance of a loan or line of credit is forgiven and the borrower need not pay it back. It usually applies to unsecured debt like credit card debt. For secured debt like a home mortgage, failure to pay usually results in foreclosure or repossession rather than debt forgiveness.

Debt forgiveness is different from debt relief, which refers to a debt payment program that helps lessen the financial burden of debt by making payments more manageable. However, debt relief does not erase or forgive debt.

When considering debt forgiveness, it’s important to carefully weigh the pros and cons. This way, you’ll be aware of any consequences of debt forgiveness, so that you can be as financially prepared as possible.

Pros of Debt Forgiveness

Debt forgiveness is an appealing option for many who are struggling to make payments or who can’t afford interest rates for any reason. Below are some benefits of debt forgiveness:

  • You may be able to avoid bankruptcy
  • You may be able to pay much less than you originally owed
  • You may be able to pay your debt in less time than originally planned

Unfortunately, these benefits don’t come without strings attached. There are some caveats to be aware of when considering debt forgiveness.

Cons of Debt Forgiveness

Many borrowers are surprised to learn that debt forgiveness can actually be quite expensive. If not carefully planned, you may end up in a worse financial situation than before. The following are potential negative effects of debt forgiveness:

  • You can severely damage your credit score
  • You’ll owe taxes on the forgiven amount
  • You may end up owing more than you originally owed

Because of these downsides, many people choose to explore different debt management options.

Debt Forgiveness vs. Debt Consolidation

Before deciding to pursue debt forgiveness, you may consider debt consolidation. While consolidation doesn’t get you out of debt, it can help you save money on unnecessary interest charges. 

Debt consolidation strategies include making a balance transfer, taking out a home equity loan or taking out a personal loan.

Perhaps the most common method is a balance transfer, where you move a debt to a new credit card that offers 0% APR for a few months. This provides you time to pay off your debt without accruing interest. You can also choose to take out a personal loan or home equity loan to pay off your debt. The strategy here is that your new loan would have a lower interest rate than that of your existing debt, which can save you money.

Just be wary of for-profit companies that promise debt relief via consolidation, as they’re often pricey. Instead, look to nonprofits such as the National Foundation for Credit Counseling.

How Do I Get Debt Forgiveness?

If you’re moving forward with debt forgiveness, you have a few options depending on loan type and your overall personal and financial situation. 

Federal Programs

One of the few ways to get true debt forgiveness without consequences is to see if you’re eligible for a special program. These are typically available only for student loan debt and home mortgages.

In mid-2019, student loans totaled $1.6 trillion. To help alleviate this, the Public Service Loan Forgiveness (PSLF) program provides Direct Loan forgiveness for full-time workers who have made 10 years’ worth of qualified monthly payments. Check your eligibility here.

The Mortgage Forgiveness and Debt Relief Act, passed in 2007, can help some borrowers by excluding up to two million dollars in forgiven mortgage debt from their tax returns so that they don’t owe income tax on the forgiven debt. This allows forgiven mortgage debt and foreclosure balances to be truly penalty-free.

You may be eligible for other federal programs to help manage debt. To explore your options further, visit the Federal Trade Commission’s page on coping with debt.

Settlement

Settlement is by far the most common form of debt forgiveness. It’s the process of negotiating your debt with the goal of only repaying a portion of your outstanding balance. The rest is forgiven, meaning repayment is not necessary.

Borrowers tend to choose debt settlement if they can’t afford expensive and persistent debt payments. They may also choose this route as an alternative to declaring bankruptcy, since debt settlement should only stay on your credit report for seven years. 

The debt settlement industry saves consumers 1.6 billion annually, according to the American Fair Credit Council.

A recent study shows that the debt settlement industry saves consumers $1.6 billion annually. However, it’s important to watch out for hefty fees from these companies. If you can’t afford a debt settlement representative, negotiating on your own is still an option.

First, you’ll need to determine your outstanding balance and what monthly payment you can afford. Next, contact your creditor. You’ll need to explain why you can no longer afford the loan and then negotiate a lump sum. If they agree, ask for a written letter so you have legal proof of the settlement.

Statute of Limitations

If you’re seeking debt forgiveness for credit card debt, you may be able to leverage the statute of limitations (SOL). The SOL is applicable once a certain amount of time has passed (typically three to 15 years depending on what state you live in) and your debt collector hasn’t pursued debt collection in court. After this time frame, they have no legal claim to your money, and your debt can be forgiven. However, this approach is risky for a number of reasons.

In order for debt to be forgiven under the SOL, there must not be any payments made towards or any acknowledgment of the debt. During this time, fees and interest may accrue and your creditor may be able to successfully sue you. After your SOL expires, you may still be sued—but you can use the SOL as a defense in court.

Bankruptcy

Filing for bankruptcy is a last-resort option that comes with a hefty cost that may follow you for the rest of your life. That said, it may help forgive some of your debt. 

If you file for chapter 7 bankruptcy, your credit card debts will be forgiven only after your assets are sold to creditors to pay off as much of the outstanding balance as possible. However, your car and home are typically excluded from what can be sold, depending on your situation.

If you file for chapter 13 bankruptcy, you’re still required to pay off your debts. However, the court will assign you a payment plan spanning anywhere from three to five years, and they may reduce your outstanding balance to lessen the financial burden.

What Are the Ramifications of Debt Forgiveness?

After you have a portion of your debt forgiven, you may feel like you’re out of the woods—and for the most part, that’s true. However, there are a few things you’ll need to be aware of so that you’re prepared for the effects debt forgiveness may have on your taxes and credit score.

Taxes

No matter which debt forgiveness route you take (with the exception of bankruptcy), you’ll likely end up with a higher taxable income. If the amount of forgiven debt exceeds $600, you’ll receive a 1099-C form titled “Cancellation of Debt” from the creditor. 

Debt forgiveness exceeding $600 requires the 1099-C form, "Cancellation of Debt."

With this form, you report the amount of your forgiven debt to the IRS and pay income tax on it. When you first take out a loan or borrow money, you’re not charged taxes on it because there’s the assumption that you’ll pay it back. But after debt forgiveness, that assumption no longer applies, which is why this essentially “free money” is now considered taxable income.

The upside is that the income tax you owe on the forgiven debt amount is less than what you would have to pay if you still owed the debt. Make sure to plan for this expense so that it doesn’t surprise you, especially if the forgiven amount is sizable.

Consider contacting a qualified tax professional for help accurately filing your taxes. Then, once you properly report your debt forgiveness to the IRS, you’ll want to check your credit report.

Credit Score

The unfortunate reality is that debt forgiveness tends to negatively impact credit score. The effect to which debt forgiveness impacts your score largely depends on the method you choose to obtain it. 

Declaring bankruptcy can drop your credit score by 200 points, according to the website Debt.org.

Bankruptcy can be the most devastating option for your credit score. According to Debt.org, FICO scores of 780 could take a 200-point dip, and scores of 680 could take a hit of 130 – 150 points. If your credit score is much lower than 680, you may not see as large of a dip. Regardless, your credit score will likely end up poor. 

Using settlement or the statute of limitations to obtain debt forgiveness may hurt your credit score almost as much as bankruptcy, and the debt may stay on your credit report for up to seven years. However, if you change the status of your debt from “not paid” to “settled,” you may see slight improvements to your score.

Debt forgiveness provides a much-needed solution for borrowers struggling to make payments. However, it also comes with stipulations. When considering which debt management plan is right for you, a little careful planning can go a long way.

If overwhelming debt has caused your credit score to dip below where you’d like it to be, let us help. We can take a look at your credit and assist you with moving forward.


Reviewed by Alexis Peacock, an Associate Attorney at Lexington Law Firm. Written by Lexington Law.

Alexis Peacock was born in Santa Cruz, California and raised in Scottsdale, Arizona. In 2013, she earned her Bachelor of Science in Criminal Justice and Criminology, graduating cum laude from Arizona State University. Ms. Peacock received her Juris Doctor from Arizona Summit Law School and graduated in 2016. Prior to joining Lexington Law Firm, Ms. Peacock worked in Criminal Defense as both a paralegal and practicing attorney. Ms. Peacock represented clients in criminal matters varying from minor traffic infractions to serious felony cases. Alexis is licensed to practice law in Arizona. She is located in the Phoenix office.

Note: Articles have only been reviewed by the indicated attorney, not written by them. The information provided on this website does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client or fiduciary relationship between the reader, user, or browser and website owner, authors, reviewers, contributors, contributing firms, or their respective agents or employers.