Debt Forgiveness: The Options & Consequences

You’ve done it with bad relationships in the past. You’ve forgiven and forgotten. Can you do the same thing with your bad relationship with overwhelming debt? Often, you can have it forgiven. But instead of forgetting, you may want to learn and grow from the experience.

Debt forgiveness is a good option for many people who are having financial difficulty and struggling to make their monthly debt payments. But there can also be negative consequences. This article will help you understand debt forgiveness options and their consequences, so you can decide what’s best for you and your family.

What is debt forgiveness & how does it work?

Debt forgiveness is when one of your lenders forgives or erases some or all of your debt. This debt could be from a line of credit like a credit card, a student loan, or an installment loan. Also, debt forgiveness doesn’t necessarily mean that your debt gets totally erased. You can settle a debt for less than what you owe. When you do this, the lender forgives the remainder of what you owed. 

As you can imagine, debt settlement isn’t always easy to come by. Usually, lenders that offer loan forgiveness programs have eligibility requirements. To determine whether and how much of your debt to forgive, your lender will consider your financial circumstances and how much debt you owe. This means different people might have different debt forgiveness options.

Debt forgiveness is usually available for unsecured debts like credit cards, personal loans, or student loans. Secured debts like a mortgage or a car loan are not usually eligible for debt forgiveness. If you default on a secured debt, the lender will likely pursue foreclosure or repossession. If you are having difficulty paying the minimum payments on your secured debts you should look at options like a loan modification, forbearance, refinance, or bankruptcy.

Before you pursue debt forgiveness, debt consolidation, or any form of debt relief, including bankruptcy, be sure you understand the pros and cons of each option. To understand the pros and cons of different debt-relief options, consider contacting a nonprofit credit counselor or financial counselor. They can give you an expert opinion and help you get a handle on your financial situation. Here are some other pros and cons to consider.

Debt Forgiveness Pros & Cons

No matter how you choose to tackle your debt, there will be pros and cons. The same is true for debt forgiveness. There are great benefits but also serious consequences. Things can get even stickier if you don’t plan appropriately or your circumstances change.

If you’re struggling financially but want to avoid bankruptcy, see if you’re eligible for debt forgiveness. If you have all or some of your debt forgiven on your largest debt or debts, that will free up discretionary income. Attempting debt forgiveness and other alternatives to bankruptcy might allow you to maintain a better credit score, keep your personal financial situation private, and avoid property loss. Those are all possible negative consequences of a bankruptcy filing.

If you can get a lender to forgive a debt, you'll benefit by paying less than the total amount you owed. Having some of your debt forgiven may free up extra money for you to use to pay down other debts. You might try the debt avalanche or debt snowball method to pay on other debts that aren’t eligible for debt forgiveness. Debt forgiveness can also help you pay off your debts faster. You’ll save money on interest and may see a positive effect on your credit score. If you have a debt repayment plan to tackle all your debts, debt forgiveness can expedite your plan and help you pay off your debt even sooner than expected.

Just remember, there are also downsides to debt forgiveness. It can significantly damage your credit score because you are not paying in full on amounts you owe. Debt forgiveness can make it more difficult for you to obtain financing or lines of credit in the future as lenders may view it negatively. Also, if a lender forgives all or some of your debt, there will be tax consequences. The amount that’s forgiven will be counted as income on your upcoming tax return, which means you may have to pay income tax on it.  

When done hastily or improperly, debt forgiveness can make things worse and you can end up owing more than you owed before the debt forgiveness. One way this might happen is by using an unreputable debt settlement company. Be wary of private debt settlement agencies that aren’t highly rated by the Better Business Bureau. These agencies sometimes promise a lot, don’t deliver, but still charge outrageous fees.

Debt Forgiveness vs. Debt Consolidation

Debt forgiveness and debt consolidation may sound similar, but they are different and should be used in different circumstances. If you have a debt forgiven, you no longer have to pay part or all of the debt. If you consolidate your debt, you’re still on the hook to repay the full amount, but you may be able to do so at a lower interest rate with a lower monthly payment.

Debt consolidation is when a borrower combines multiple debts into one debt. For example, if you had several high-interest credit cards, you might try getting a consolidation loan. This loan allows you to pay a single fixed monthly payment with a lower interest rate. Sometimes people consolidate their debt by doing a credit card balance transfer. Some cards offer a promotional period—15-18 months is typical— with low or no interest.

Think hard about whether debt consolidation is right for you. You may need to change your spending habits. Or maybe another debt-relief option is better for your situation. Sometimes you just need to stay the course with your budget and debt repayment plan.

Common Types of Debt Forgiveness

When looking at debt forgiveness, first consider the type of debt you’re looking to have forgiven. Is it credit card debt? Student loan debt? Medical debt? Mortgage debt? Tax debt? Or a combination of debts? Knowing what type of debt you are struggling to make minimum monthly payments will help you decide which route to take. You’ll also want to consider other aspects of your financial situation and your long-term goals. 

You may qualify for special debt forgiveness programs if you:

• Are a low-income individual

• Are on permanent disability

• Have been affected by the coronavirus pandemic

• Are a full-time student

• Work in a qualifying occupation

Make use of the resources available to you. Learn as much as you can about debt forgiveness through sources like Upsolve’s Learning Center, the Consumer Financial Protection Bureau, a trusted credit counselor, or even your loan servicer. Contact your lenders by phone or through your online borrower’s portal to discuss your options if you’re struggling to make your minimum monthly payments. Often they can help you figure out a repayment plan.

Here’s more information about common types of debt forgiveness.

Student Loan Debt Forgiveness

Student loan forgiveness is a hot topic these days. President Biden has considered numerous student loan forgiveness proposals and is likely to revisit the subject. Student loan payments were paused in March 2020 as part of coronavirus pandemic relief. Then, President Biden extended the payment pause through the end of September 2021. But even outside of the extraordinary circumstances of the pandemic there have long been student loan forgiveness programs.

People working in public service occupations like teaching may be eligible to have their student loan debt forgiven. Other times, student loan debt may be forgiven after a borrower pays on an income-driven repayment plan for a set time. Student loan debt may also be discharged, but this is rare.

Student loan forgiveness works like ordinary debt forgiveness but is specific to student loans issued by the U.S. Department of Education. It doesn’t apply to student loans issued by private lenders like banks. The federal government has outlined several federal student loan debt forgiveness programs. The most popular and most widely used programs are the Teacher Loan Forgiveness program and the Public Service Loan Forgiveness (PSLF) program. Income-based repayment programs that have a forgiveness element at the end of the life of the loans are also common.

Teacher Loan Forgiveness

If you’re a teacher who is struggling to pay your student loans off, please consider the Teacher Loan Forgiveness program. To be eligible you have to be an educator who works in a school or educational service agency in a low-income area for five consecutive years.

Public Service Loan Forgiveness (PSLF)

The Public Service Loan Forgiveness (PSLF) program is for people who work for the government or a qualifying nonprofit in a public service capacity. Unlike the Teacher Loan Forgiveness program, the PSLF doesn’t focus as much on a borrower’s specific occupation. It matters more who your employer is and how long you work for them. To be eligible for PSLF, a qualifying employer has to be a government organization or a tax-exempt nonprofit. Normally debt forgiveness is taxable, but debt forgiven through PSLF is not. That is a nice benefit for your years of public service.

Credit Card Debt Forgiveness

Credit card debt forgiveness can be trickier to get, but it’s not impossible. Credit card issuers and lenders are not as willing to negotiate debt forgiveness as you might hope. That is because they have other tools to collect on the debt their borrowers owe.

But, you can get your credit card debt forgiven if your debts are uncollectible or you make a reasonable settlement offer that your lender accepts. You might offer to pay 50% of the outstanding debt you owe in one lump sum. If your lender accepts this offer, the remaining 50% of your debt will be forgiven. This may lower your credit score and have tax consequences.

Mortgage Debt Forgiveness

If you’re struggling to make your monthly house payment, your mortgage lender may be willing to work with you, but you have to ask. Evaluate your financial situation, then call your lender and ask what options they have to help.  Your lender may suggest a loan modification or a mortgage forbearance to ease your overall debt burdens. 

If you foresee a long-term financial struggle, a loan modification might be a good idea. This may increase your repayment term (how many years you pay), but it can also reduce your monthly payments. If you’re struggling due to a short-term circumstance, a forbearance might be the way to go. This allows you to skip a set number of payments, though you’ll eventually need to make them up.

How To Obtain Debt Forgiveness

Some people can get debt forgiveness by directly contacting and negotiating with their lenders. Other people prefer to hire a credit counselor or private attorney to work on their behalf. Finally, some people work with debt settlement and debt relief agencies to address their overwhelming debt situation.

Here’s a list of popular federal student loan debt forgiveness programs:

• Public Service Loan Forgiveness (PSLF) Program

• Teacher Loan Forgiveness Program

• Perkins Loan Cancellation Program

• Nurse Corps Loan Repayment Program

• National Health Service Corps Loan Repayment Program

• Student to Service Loan Repayment Program

• Indian Health Services Loan Repayment Program

• National Institute of Health Repayment Program

• Military Healthcare Professionals Loan Repayment Plan

• Department of Justice Attorney Student Loan Repayment Program (ASLRP)

• John R. Justice Student Loan Repayment Program

• Herbert S. Garten Loan Repayment Assistance Program

In terms of mortgage debt forgiveness programs, you’ll want to look into:

• FHA Home Affordable Modification Program (HAMP)

• The Hardest Hit Funds

• HUD’s Making Home Affordable Program

Debt Settlement

Debt settlement is a good option for some people. You can do this on your own or hire an agency to do it for you. If you hire an agency, you’ll make one payment to the debt settlement company, who makes payment to your creditors. Debt settlement might be a good solution for you if you are looking to avoid bankruptcy, get some breathing room from your lenders and collection agencies, and reduce your total debt amount. Either way, there’s going to be a short-term drop in your credit score, and you’re going to have some tax ramifications as well.

Statute of Limitations

The statute of limitations is the clock your creditor races against to collect on your debt. Each state has a different timeline for different types of debt collection, but collection agencies or creditors cannot collect on a debt whose statute of limitations has passed. This is different from the length of time a debt may appear on your credit report. Though many states have statutes of limitations ranging from three to 10 years, debts that have gone to collections will stay on your credit report for seven years. 

Filing for Bankruptcy

Sometimes filing for bankruptcy is a better option than debt forgiveness. In Chapter 7 bankruptcy, most of your debts are discharged and your financial slate is wiped clean. A Chapter 13 bankruptcy is more like a payment plan. Each type of bankruptcy has its pros and cons and each is best utilized in certain scenarios. Make sure you research the requirements for each before filing. Upsolve offers many resources for bankruptcy including a free online filing tool and access to a free consultation with a private attorney.

Debt Forgiveness Consequences

As a borrower, you must be prepared for the consequences of debt forgiveness. Namely in terms of your credit score and taxes.

Credit Scores

Your credit score often will decrease after receiving debt forgiveness. While this can be discouraging, it is a short-term consequence and you can repair your credit and rebuild your credit score after receiving debt forgiveness. Keep in mind that your credit score is decreasing because you are not paying the full amount of the initial loan or line of credit. Your credit score could drop as much as 100 points or more immediately after debt forgiveness.

Taxes

If you have more than $600 of debt forgiven, it is typically considered taxable income. So if you were able to negotiate debt forgiveness of a good chunk of money, you’ll end up being in a higher tax bracket when you file your taxes with the IRS. You can take steps to lower your taxable income so you don’t have complications with the IRS. For example, you could make charitable donations, itemize your deductions, or contribute to an IRA or 401(k) to lower your taxable income.  A private attorney, financial advisor, or accountant can help you figure out how to report this on your taxes. They will have also more detailed strategies to minimize your tax complications.

Let’s Summarize...

Debt forgiveness can be a great tool in the right circumstances. Lenders may require you to pay part of the debt while forgiving the rest. Though debt forgiveness can help relieve financial stress if you can’t pay on your loans, it also has consequences. Your credit score may go down and your income tax may go up. 

Also, only certain types of loans are typically eligible for forgiveness. Unsecured debts like credit card debt and student loans are good examples. Secured debt like a mortgage is not usually eligible for loan forgiveness, though your lender can tell you what options are available if you’re struggling to make those payments. Use the resources available to you and consider all your options before deciding which debt-relief option is right for you.