Can Unsecured Loans Be Written Off?

Unsecured loans are a common financial tool, but understanding what happens when they become difficult to repay can be complex. When a lender refers to an unsecured loan as “written off,” it signifies an internal accounting adjustment. This action does not automatically eliminate the borrower’s obligation to repay the debt. The implications of a loan being written off differ significantly for the lender and the borrower.

What “Written Off” Means for the Lender

For a lender, “writing off” an unsecured loan, often referred to as a “charge-off,” is an internal accounting procedure. This action recognizes a significantly decreased likelihood of collecting the debt. Typically, a loan is charged off after a period of prolonged non-payment, around 180 days past due. This adjustment removes the uncollectible amount from the lender’s active assets on their balance sheet.

Despite this internal accounting entry, the borrower’s legal obligation to repay the debt remains. Lenders frequently continue collection efforts, even after a loan has been charged off. These efforts might involve internal collection departments or the sale of the debt to a third-party debt collection agency. The new debt owner can pursue collection.

Pathways to Debt Discharge for Borrowers

While a lender’s write-off does not extinguish a debt, borrowers have legal mechanisms to achieve a discharge of their unsecured loan obligations. These pathways formally terminate the borrower’s responsibility.

Bankruptcy

Chapter 7 bankruptcy is a common method for individuals to discharge unsecured debts. This process eliminates the borrower’s personal liability for many unsecured obligations, providing a fresh start. Unsecured debts typically discharged in Chapter 7 include credit card debt, personal loans, medical bills, and some older tax debts. Once a debt is discharged through bankruptcy, creditors are legally prohibited from attempting to collect it. A Chapter 7 discharge order generally occurs about four months after the petition is filed.

Debt Settlement

Debt settlement is an agreement between a borrower and a creditor to resolve a debt for less than the full amount owed. It typically involves a lump-sum payment or a structured payment plan. Borrowers can negotiate directly with creditors or use the services of a debt settlement company. While it can provide financial relief, the account will generally be marked as “settled” or “paid-settled” on credit reports rather than “paid in full.”

Other Scenarios

Unsecured debt might be discharged in less common instances. If a borrower passes away, unsecured debts like credit card balances or personal loans are typically paid from their estate. If the estate lacks sufficient assets, the remaining balance may go unpaid, and family members are generally not responsible unless they co-signed. Direct forgiveness by a lender, outside of a formal settlement, is rare and occurs only under specific circumstances.

Tax Consequences of Debt Forgiveness

When a debt is forgiven or settled for less than the full amount, the IRS generally considers the difference taxable income to the borrower. This is known as “cancellation of debt (COD) income.” Lenders are usually required to issue Form 1099-C, Cancellation of Debt, to the borrower and the IRS for forgiven amounts of $600 or more. This form reports the canceled debt.

However, exceptions or exclusions can prevent the forgiven amount from being taxed. One common exclusion applies if the taxpayer was insolvent when the debt was canceled. Insolvency means total liabilities exceeded the fair market value of assets immediately before cancellation. The amount excluded due to insolvency is limited to the extent of insolvency.

Debt discharged through a Title 11 bankruptcy proceeding, such as Chapter 7, is also excluded from taxable income. To claim these exclusions, taxpayers typically need to complete and attach IRS Form 982.

Credit Score Impact

When an unsecured loan is written off, defaults, is settled, or discharged through bankruptcy, these events significantly impact a borrower’s credit score. A charge-off, a severe negative mark, indicates a creditor has written off the debt as a loss. This entry, along with missed payments, can severely harm credit scores. Payment history accounts for a substantial portion of a credit score, and a charge-off can lead to a significant point reduction (50-150 points).

These negative events are reported to credit bureaus and remain on credit reports for years. A charge-off typically stays on a credit report for seven years from the original delinquency date. Debt settlements also appear on credit reports for about seven years.

A Chapter 7 bankruptcy remains on a credit report for up to 10 years from filing, while a Chapter 13 bankruptcy stays for seven years. These negative marks can affect future borrowing ability, leading to denials for new credit or higher interest rates. Such derogatory information signals increased risk to lenders.