Charge-Off vs. Cancellation of Debt

What happens when you can’t afford to pay back your debt? Depending on your circumstances, things can unfold in a few different ways.

If you’re facing a financial hardship and you ask your creditor for help, they might be able to “cancel” or forgive some or all of what you owe.

However, if you simply stop paying the debt, it will usually be charged off, meaning the creditor will send it to a debt collector.

Which option is best? As a financial expert and former NFCC-certified credit counselor, I’ve learned that many people don’t know which outcome is better, or even realize they have options, so it’s understandable if you’re confused.

In short, debt cancellation is the ideal choice since it typically does a lot less damage to your credit scores, and it relieves you of the legal obligation to pay the debt. But both options can have negative consequences you should be aware of.

What Is a Charge-Off?

When a creditor determines that you’re not going to pay back your debt, they usually charge it off, meaning they sell the account to a debt collector. This usually happens once you fall behind 180 days on your payment, but the timeline depends on the creditor.

Do you still owe the debt after a charge-off? Absolutely! However, if you want to pay it off, or settle it for less than you owe, you’ll have to make an arrangement with the debt collector and not the original creditor.

It’s best to avoid a charge-off if you can, since charge-offs appear on your credit reports and do major damage to your credit scores. On top of that, the debt collector can sue you for the money.

In my experience, a lawsuit is most likely to occur if you owe around $2,000 or more, but each debt collector is different. You can also put yourself at more risk of a lawsuit if you ignore calls from a debt collector and fail to read the letters they send.

What Is Cancellation of Debt?

Cancellation of debt refers to what happens when a creditor agrees to let you pay less than what you owe. This can include forgiving the entire balance remaining on the account or just cancelling some portion.

When a creditor cancels your debt, you are no longer legally obligated to pay the money back. However, most people don’t realize that there can be negative outcomes associated with debt forgiveness. For example:

• Your credit reports will show that you did not pay the full amount you owed, which can make it more difficult to qualify for some loans and credit cards in the future.
• Canceled debt is usually considered taxable income, unless it’s cancelled due to bankruptcy or through special programs such as the Public Service Loan Forgiveness (PSLF)

With that said, if the amount forgiven is significant, or if you can’t afford to keep up with the payments, debt cancellation can still be a huge financial relief.

Side-by-Side Comparison Table

When Both Can Occur

In some cases, you might have a debt that gets charged off and cancelled.

How does that happen? It can only happen if your debt is charged off first. Then, once it goes to collections, you can try to get some of your balance canceled by negotiating a settlement with the creditor.

There are a few different ways to go about getting charged-off debt canceled, with some options being much riskier than others:

• For-profit debt settlement: For-profit companies charge you to handle the negotiations, but hiring them is very high risk since they can’t legally guarantee any specific outcomes, and their costly services often do severe damage to customers’ credit scores.
• DIY debt settlement: You can communicate directly with collectors to negotiate your own settlement agreements. DIY debt settlement is moderately risky since you can potentially make mistakes, like agreeing to send money when you have limited income that’s exempt from lawsuits.
• Less Than Full Balance Program: Eligible debtors can use InCharge’s nonprofit debt settlement program. With this program, creditors agree up-front to accept just 50% to 60% of what you owe, and then you pay the rest off in monthly installments over a three-year period.

Whichever option you choose, it’s worth noting that settling a debt does not get the debt removed from your credit reports early. According to FICO, it can even cause your credit scores to drop. On top of that, you’ll also need to be prepared to pay income taxes on the debt that’s forgiven.

Credit Score & Reporting Effects

It’s impossible to say how much your credit scores will change when you experience a charge-off or debt cancellation. Why? Because the shift in your scores will depend on a variety of factors, including your history of making debt payments on time.

What we do know is that a charge-off is likely to have a much more severe, negative impact. That’s because it’s a sign that you are not paying back your debt as agreed, and it indicates that you could be a risky borrower in the near future.

Even if you pay off your debt after it’s sold to collections, it will show as a “paid charge-off,” on your credit reports, which may scare new creditors.

When it comes to cancelled debt, a few things can happen to your credit scores. Loan forgiveness can cause a temporary dip in your scores if it means closing the only active loan on your credit reports. However, the more debt you have forgiven, the more likely you are to see your scores improve.

Tax Ramifications

When your debt is charged off to a collections agency, there aren’t any tax ramifications. But if you have $600 or more of your debt cancelled, for any reason other than a bankruptcy or a qualifying program, you could end up owing extra money to the IRS.

That’s because the IRS says that most forgiven or cancelled debt is taxable income. In other words, the amount of debt that gets cancelled will be added to your income calculation for the year, and you’ll be taxed on it at the same rate as the rest of your income.

So, if you have $600 or more cancelled, you can usually expect to receive a Form 1099-C showing the amount you have to report to the IRS as income.

What to Do If Your Debt Is Charged-Off or Canceled

I’ve counseled many individuals who believed that they didn’t have to worry about their debt after it was charged off or cancelled. Unfortunately, they were mistaken.

A cancelled or charged off debt still requires some attention to be fully resolved. For example, you’ll want to check your credit reports to make sure the transaction is reported correctly. Here’s everything else you need to know.

Charge-Off

If your debt is charged off, contact the original creditor to confirm who the debt was sold to. You can also pull your credit reports for free from AnnualCreditReport.com to see who currently owns the debt.

If the debt collector contacts you, don’t offer any payments you can’t afford to make. Instead, ask them to send you a letter that verifies the details of the account. Then, you have a few different options:

• Agree to the payment terms the debt collector is requesting.
• Wait and see if the debt collector notifies you of an impending lawsuit. If this happens, you can try and negotiate a settlement or offer full payment to avoid court.
• Try to negotiate a payment for less than what you owe, by using one of the debt settlement options listed above. (See the section titled “When Both Can Occur.”)

If you’re not sure which option is best, one of InCharge’s NFCC-certified credit counselors can help you by reviewing your budget and credit reports and suggesting the best solution.

Cancellation of Debt

If your debt is cancelled, one of the most important things to do is keep a statement from the creditor that proves your debt was canceled. This will come in handy if there’s ever a dispute about what you owe.

In addition to that, make sure you understand whether or not you owe taxes on the canceled debt. You might want to consult with a tax professional if you’re not sure whether or not this is the case.

Most people should be prepared to pay taxes on canceled debt. If the creditor sends you a Form 1099-C, hold onto it so you can refer to it when you file taxes.

Special Cases: Bankruptcy

Bankruptcy has many downsides, but the main upside is that you don’t have to pay any of the debt that’s discharged. On top of that, you don’t have to pay taxes on the discharged amount.

The main problem with filing is that it has a severe negative impact on your credit. After you file, you’ll want to check your credit reports and start looking for ways to regain points.

The best way to rebuild your scores is by making on-time payments on any loans or credit cards you have open. Depending on your situation, this may include student loans, since they can’t be discharged in a bankruptcy.

Is a Charge-Off or Cancellation of Debt Right for You?

Debt cancellation is always a better solution than a charge-off.

With debt cancellation, you may have to pay some taxes afterwards, but it will only equal a percentage of the amount that was forgiven. Additionally, there may be minimal damage to your credit scores, and in some cases, your scores will even improve.

With charge-offs, you will likely see significant credit score damage, since debt isn’t charged off until you miss multiple payments. On top of that, you’ll still owe all of the money after your account is moved to collections, and you could eventually be sued for the debt.

If you’re still not sure what’s the best solution is for your debt, know that there are professionals who can help.  You may want to speak to find a consumer law attorney if you have questions about debt collections, or talk to a tax professional for questions about debt cancellation.

A certified credit counselor can also help you by reviewing the details of your situation and giving you personalized recommendations for managing your debt.