Question: We have a lot of credit card debt. We trimmed down our spending but still cannot get ahead. What is the difference between credit counseling and debt consolidation? Will they affect our credit score?  —Barb P., Colorado Springs

Answer: A credit counselor helps you develop a plan to get out of debt; debt consolidation is a tool they may use to do so.

If you choose to work with a credit counselor, stick with a nonprofit agency like the National Foundation for Credit Counseling to avoid scams. Remember, nonprofit does not mean free. You may have to pay a low fee for this service. 

A credit counselor negotiates directly with your creditors to work out terms that you can meet. The result is a debt consolidation plan. You then make monthly payments to the counseling agency, and they will pay your creditors. This isn’t free, either, by the way. You will typically be charged a percentage of your total payment. 

Beware: Debt consolidation might hurt your credit — especially if you get hooked up with a scam agency that doesn’t pay your creditors on time. A lender may also view your participation in a repayment plan negatively. 

Avoid companies with screaming headlines about cutting your payment in half. Think about it — If you are really up to your eyeballs in debt, why would anyone lend you money on better terms? There is always a catch. 

Question: We settled with our credit card company by paying them less with one lump sum. We also sold our home in a short sale for less than what we owed on it. We are hearing that will have to pay taxes on all of this “forgiven” debt. Is that true?  —Ron M., Colorado Springs 

Answer: It’s half true. Each type of debt is treated differently. 

Let’s say you worked out a deal with your credit card company to pay off your $15,000 balance with a lump sum payment of $10,000. They will still mail you a 1099-C tax notice at the end of the year for taxes owed on that $5,000 of forgiven debt. Cancelled credit card debt is almost always taxable as income, EXCEPT when you are insolvent or if your debt was erased in bankruptcy. 

What is insolvent? The IRS defines it as when “your debts exceed your total assets.”

In a short-sale transaction, the lender allows you to sell your home for less than your loan balance. So if you sell your home for $150,000 instead of the $180,000 mortgage balance, they will forgive you the $30,000 difference. This cancelled debt is not taxable under the Mortgage Debt Forgiveness Act.

 Both options do give you some breathing room, but they may both negatively affect your credit score, so consider them last resorts. (Short sales are not as damaging to your credit as a foreclosure.)

There are ways to avoid drowning if you’re up to your eyeballs in debt. Just be very aware of the price you will ultimately pay.

 Mystified by money? Ask Denisa and improve your financial literacy. Denisa Tova MBA, CFP®, CDFA is a Colorado Springs-based Certified Financial Planner and CEO of DaVinci Financial Planning. Submit financial questions to her at denisa.tova@gazette.com.