Latest posts by Kumiko Ehrmantraut (see all)
- How to Deal with Debt in Collections - April 14, 2021
Most people have every intention of repaying the money they borrow. But sometimes, life doesn’t go as planned.
You or a loved one might get sick or hurt, making it hard to pay your bills. You could lose your job or go through a divorce. Or, like my former self, your financial struggles might come from not following a budget.
When you can’t keep up with your bills, your creditors may sell your unpaid debts to third-party debt collectors. Unfortunately, collection accounts can hurt your credit rating and cost you money.
The good news is that having collection accounts doesn’t mean all hope is lost. You can make a plan to address your collection accounts, rebuild your credit, and improve your overall financial picture.
First, Gather Intel
You can’t build a successful plan to deal with debt collectors until you gather the facts about who you owe money to and how much you owe. Looking at your overall debt picture can be scary — I know. But this information is critical if you want to change your situation.
Your credit reports are a great place to gather intel about the debts you owe. You can claim free credit reports from Equifax, TransUnion, and Experian once every 12 months at AnnualCreditReport.com. (These free reports don’t include your credit scores — at least not without additional fees.)
You can also access free credit reports and scores online:
- Credit Karma — Free weekly credit reports and scores (VantageScore 3.0) from TransUnion and Equifax
- Experian — Free Experian credit report with FICO Score 8 each month
After downloading your credit reports, review them, and make a list of the debts you owe. (Tip: You can use the Budget By Paycheck Workbook to help track your progress.)
What You Can Afford and Which Debts to Pay First
Next, look at out how much money you can afford to pay toward debts each month. Just because a debt collector is hounding you doesn’t mean the expense fits into your budget. If you’re behind on your current bills, now probably isn’t the time to send money to a collection agency.
Making a budget can help you compare your income with household expenses and current debts like an auto loan, mortgage, active credit cards, etc. Cutting expenses and negotiating lower bills may free up more cash you can use to pay down collections or other debts.
Finally, you can start thinking about which debts to pay off first. Depending on your financial goals, you can choose between the debt avalanche and the debt snowball method. The method you pick will determine your debt payoff order.
The debt avalanche method may save you money in interest. The debt snowball method might help you improve your credit score quicker. (This matters if you’re trying to buy a home or want better credit for other reasons.) Often, it’s best to pay off other high-interest debts before you tackle collections.
Plan Your Payment Approach
There are three approaches you can use to pay collection accounts when the time is right:
- Settle for Less
- Pay in Full
- Make Payments
In my opinion, settling collection accounts for less than you owe is the best choice. Here are the benefits and drawbacks of all three payment approaches so you can weigh your options.
1. Settle For Less
When a third-party debt collector buys an unpaid debt from an original creditor, it usually only pays pennies on the dollar. You could owe a company $2,000, but a collection agency might only pay $100 to purchase the account. Because of the system, you can often settle collection accounts for less than you owe. After all, if you pay the collection agency half of what you owe to settle the debt ($1,000), it still makes a $900 profit.
Your best bet is usually to save enough money so that you can try to negotiate a debt settlement on your own. You can create a sinking fund or dedicated savings account to use for a lump-sum settlement offer in the future. (If your setting up a new savings account, it's smart to get one that offers a high interest rate, like CIT Bank's Savings Builder.)
Once you save 40%–60% of the balance, you can call the collection agency to see if it’s willing to negotiate. If it agrees to a settlement, get the offer in writing before you make a payment.
The downside to settling collections is that if the debt collector forgives more than $600, the IRS may consider the savings as taxable income. This could potentially increase your tax obligation if you don’t qualify for an exemption. (Talk to your tax professional for advice.) Even if you owe taxes on the savings, you’ll likely come out better financially than if you had paid the full amount.
2. Pay In Full
If you want to take care of a collection account, but you don’t want to try to negotiate for less, you can choose to pay in full. You should still save your payoff amount in advance and get your outstanding balance in writing from the collection agency before you pay.
The biggest downside to paying in full is that it’s more expensive. Plus, paying a collection in full generally isn’t any better for your credit scores than settling in full. However, if you pay in full, then you don’t have to worry about claiming any extra savings on your tax return.
3. Make Payments
Some collection agencies will let you set up a payment plan to chip away at your debt little by little. Making payments to a collection agency may seem like an affordable option if you don’t have the money to pay or settle your debt in a lump sum. But this approach could backfire.
Every state has a statute of limitations that controls how long a debt collector can sue you over an unpaid debt. After somewhere between 3-10 years, unpaid debts become “time-barred” in most states. Making even one small payment on a collection account could reset this debt collection clock.
Another problem with making a payment plan with a debt collector is that it may cost more. If you save a lump-sum settlement before you contact a collection agency, you can often satisfy the debt for less.
You’re Not Alone
I know what it’s like to feel overwhelmed by debt. Yet even as a single mom with limited income, I was able to take control of my budget and start turning my financial life around. I can’t say the journey was always easy. But looking back, I can say it was worth every sacrifice.
Thank you thank you thank you! I’ve had this on my mind recently. It’s as if you were reading my mind. I have debts from medical bills. I wonder if this would work with them as well. It’s worth me trying to look into it.
I’m in the same boat. The hospital wouldn’t take less than $300 a month, which I could not afford to pay so they sent it all to a collection agency. I know they are willing to take as little as $50 a month which is doable but when you owe $30,000 I feel like it’s not worth paying into right now.
Ah, if only we could do this with federal student loans. All our other debt is paid off, but the loans are gonna take well over a decade. Sigh.