Charge-Off vs. Cancellation of Debt

Financial hardship can happen when you least expect it, and recovery can take time. If your hardship caused you to fall behind on payments, you might need to sort out what happens to your unpaid debt. 

Credit card debt is often charged off if it goes unpaid for too long. You might have seen a charge-off listed on your credit report if you've checked it recently, or gotten a notice from your credit card company about a charge-off. What it means in simple terms is that the credit card company doesn't think they'll be able to collect what they're owed. 

Maybe you've heard about debt cancellation as a way to get your finances back on track. When debt is canceled, you no longer have to pay it. Cancellation can put you in control of your debt situation as you work to improve your finances. 

If you're looking for debt relief options, here's what you need to know about charge-offs vs. cancellation.

What Is a Charge-Off?

When a debt is charged-off, it means that the creditor stops trying to collect on an unpaid debt and writes it off as a loss for accounting purposes. Charge-offs typically happen when a debtor is 90 to 180+ days past due on payments. 

Charged-off debt doesn't disappear, though. The creditor may sell it to a debt buyer, which could hire a debt collection agency to try to get you to pay. You could even wind up getting sued over the debt if it remains unpaid. 

In other words, you still owe the debt; all that changes is who has the legal right to collect that debt.

What is a charge-off on a credit card going to do to your credit? Charge-offs are considered major negative items. This could seriously damage your credit score. A charged-off account can stay on your credit reports for up to seven years, which is why it's better to act to stop charge-offs before they happen. 

What Is Cancellation of Debt?

Cancellation of debt means that a creditor agrees to forgive some or all of what you owe. When debt is forgiven, you don't have to pay it. You may, however, have to pay taxes on canceled debt. 

Debt cancellation can happen in different ways. For example, you might be able to get debt canceled through:

• Negotiation: Debt negotiation, also called debt resolution or debt settlement, happens when a debtor (or their representative) works out an agreement with a creditor to accept less than the full amount owed and cancel the rest of the debt. 

• Loan forgiveness: If you have federal student loans, you might be able to get some of what you owe forgiven. For instance, you might be eligible if you qualify for Public Service Loan Forgiveness (PSLF), or if you complete an income-based repayment plan. 

• Bankruptcy: Chapter 7 bankruptcy cancels eligible debts in full. Once your bankruptcy case is discharged by the court, you're released from any obligation to pay the debts discharged by the bankruptcy. 

Credit insurance may also cancel debt if you meet certain conditions laid out in your policy. For example, if you have credit insurance on a credit card or loan and become permanently disabled, your policy might pay the balance off for you. 

Debt cancellation can give you some breathing room, but it's likely to appear on your credit reports. 

Key Differences Between Charge-Off and Debt Cancellation

A charge-off means a creditor has given up on trying to collect a debt. Cancellation means you and the creditor have worked out an agreement for the debt to be forgiven. 

Here's a closer look at how they compare, side by side:

A charge-off won't get rid of debt—or your legal obligation to pay it. Cancellation could do that, however, which is something to consider if you need credit card debt relief.

It's also worth noting that you can have a situation where a debt that's initially charged-off is canceled later. That could happen if you have a debt that goes unpaid but take action to pursue forgiveness.

For example, you might work with a debt settlement company to negotiate a cancellation of credit card debt on your behalf for a debt that was charged-off by the original creditor. 

How Charge-Offs and Debt Cancellation Affect Your Credit

Charge-offs and debt cancellation could both cause your credit scores to drop. The exact impact to your credit can vary and is usually tied to your debt balance and payment history. The higher your credit score was before a charge-off or cancellation, the more significant the impact could be.

Here are some of the key things to know about charge-offs, debt cancellation, and your credit:

• Charge-offs can stay on your credit for up to seven years, though the impact often diminishes over time. 

• A charged-off debt on your credit reports could make it harder to get approved for new loans or lines of credit. 

• Canceled debt can appear on credit reports in different ways. For example, you may see a forgiven debt reported as "settled" or "paid as agreed."

• A "paid as agreed" status is generally better for your credit than "settled." 

On the positive side, credit scores aren't set in stone. Negative information eventually drops off your credit reports and no longer affects your scores. And while you wait for that to happen, you can work on improving your scores with on-time payments and keeping your debt levels low. 

Freedom Debt Relief is not a Credit Repair Organization and does not provide or offer services or advice to repair, modify, or improve your credit.

Tax Implications When Debt Is Canceled

Canceled debt lightens your financial load, since you now have less to pay. However, you could end up with a higher tax bill if the amount forgiven is treated as taxable income. 

You may be able to avoid owing taxes on canceled debt if you're insolvent or filed bankruptcy, or had federal student loans forgiven through the PSLF program. 

• Insolvency means that you owe more debt than you have in assets. An asset is something of value that you own, like a house, car, or bank account. The IRS has an Insolvency Determination Worksheet you can fill out to determine whether you meet this standard.

• Bankruptcy debts are excluded from your taxable income altogether under the Internal Revenue Code. Your creditors may send you a Form 1099-C showing the amount of debt canceled that you'll use to file taxes, but it isn't counted as income. 

Every situation is different and we're not tax professionals. Consult a tax professional for information on the tax implications of canceling your debt. A qualified tax professional can review the specifics of your situation and offer guidance on how canceled debt may affect you.

What to Do After a Charge-Off or Debt Cancellation

What happens next when a debt is charged off or canceled is partly up to you. While your creditors may take certain actions, you still have some control over the situation. A proactive approach could help you get through a charge-off or cancellation as smoothly as possible. 

For charge-offs

• Get in touch with the debt collector who owns the debt now to verify the details of what's owed. Get a debt validation letter so you have a paper record of your communication.

• Don't offer any payment or acknowledge that you owe the debt until it's been verified. Once you have verification, you can weigh the options.

• If you're interested in a payment plan, talk to the debt collector about what kind of arrangement you could make.

• Consider if debt settlement could help you get rid of charged-off debt for less than you owe. Decide if you'd rather negotiate the settlement yourself or work with a debt relief company. A free debt evaluation could help you decide if settlement is the right move.

For debt cancellation

• Keep detailed records of the debt that was canceled, including the name of the creditor or debt collector, the original amount owed, the settled and canceled amounts, and when you made the agreed-upon payment. 

• Prepare for potential tax implications if you think you'll tax on canceled debt. Talk to an accountant or another tax professional to understand the implications for your next tax bill. 

• Check your credit reports to confirm that the account is reported properly. Separately, you can check your credit scores to assess the impact of canceled debt. 

Next Steps After a Charge-Off or Cancellation

• Take a breath and know that you have options to manage debt that's at risk of being charged off. 

• Review the pros and cons of debt resolution to learn how it could help you deal with your debt, and the potential implications for your finances. 

Get a free debt evaluation to learn if you might be a candidate for debt settlement, or get answers to questions about how Freedom Debt Relief works.