How Will Debt Settlement Affect My Credit Score?

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How Will Debt Settlement Affect My Credit Score?

Debt consolidation usually has a negative influence on your credit score. How negative depends on a variety of factors, including your current credit situation, your creditors’ reporting practices, the size of the debts being settled, whether your other debts are in good standing, how much less than the original balance the debt is settled for, and a variety of other variables.

Key Takeaways

  • While debt settlement may be the most effective way to erase outstanding debts, it may have a negative influence on your credit score.
  • Ironically, higher credit ratings are hit worse by debt settlement than weaker ones.
  • A single substantial obligation that is one to three years past due is the greatest kind of debt to settle.
  • Do not try to pay a debt at the risk of falling behind on other responsibilities.

Why Debt Settlement Can Ding Your Credit Score

Why should it have a negative effect when you’re reducing your commitments and your creditors are being paid? Because good credit is intended to reward accounts that have been paid on time in accordance with the original credit arrangement before they are closed.

A debt settlement plan alters or cancels the original credit agreement by agreeing to pay back a part of your outstanding debt. When the lender shuts the account owing to a change in the original contract (as it often does after the settlement is completed), your credit score suffers. Other lenders are likely to take note and be wary of offering you loan in the future.

Still, the decreased financial load may be worth the ensuing dip in your credit score. High credit card balances and late or missing payments have most certainly already reduced it. Debt settlement should be explored if it would help you get on track to a better financial future.

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Let’s examine the process in more detail.

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How Debt Settlements Work

Your credit report, as you are aware, is a picture of your financial history and current. It shows the history of each of your accounts and loans, including the original loan conditions, the amount of your current debt in relation to your credit limit, and whether payments were made on time or missed. Each late payment is documented.

You may either negotiate a debt settlement deal with your lender personally or seek the assistance of a debt settlement business. In either case, you negotiate an arrangement to repay just a fraction of the remaining amount. If the lender accepts, your debt is marked as “paid-settled” and reported to the credit bureaus.

While this is better than a charge-off for your report—it may even have a little positive influence if it erases serious delinquency—it does not have the same significance as a grade that says the bill was “paid as agreed.”

The best-case situation is to agree ahead of time with your creditor to have the account listed as “paid in whole” (even if this is not the truth). This has less of an impact on your credit score.

What Sort of Debt Should I Settle?

Because most creditors are unlikely to settle debts that are current and serviced with regular payments, you should attempt to work out a settlement for older, substantially past-due debt, maybe something that has already been handed over to a collections department. It may seem counterintuitive, but your credit score normally decreases as you become more overdue in your payments.

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However, if you have an ongoing debt that was submitted to collectors more than three years ago, paying it off via debt settlement may reactivate the account and cause it to appear as a current collection. Before concluding any arrangement, be sure to clarify this with your creditor.

A debt settlement is reported to your credit bureau for seven years.

Bigger amounts, like other debts, have a proportionally larger influence on your credit score. If you are settling modest accounts, especially if you are current on other, larger debts, the effect of debt settlement may be minimal. Furthermore, settling many accounts lowers your credit score more than settling just one.

Debt Settlement vs. Staying Current

Payment history is given the greatest weight in your credit history, with current accounts having the most influence. If you are behind on other bills, it is critical to prioritize keeping a newer, current account in good standing before trying to resolve a long-overdue account.

For example, if you have an auto loan, a mortgage, and three credit cards, and one of them is more than 90 days late, do not try to settle that debt at the price of falling behind on the others. One unpaid account is preferable than several accounts with late payments.

30%

According to the American Fair Credit Council, the average amount of savings a customer experiences following debt settlement.

This may seem contradictory, but the higher your credit score before negotiating a debt settlement, the larger the reduction. According to the Fair Isaac Corporation, the group behind the FICO score (the most common type of credit score), a person with a 680 credit score (who already has one late payment on the credit card) would lose 45 to 65 points after debt settlement for one credit card, while a person with a 780 credit score (with no other late payments) would lose 140 to 160 points.

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The Bottom Line

Facing past-due debt may be frightening, and you may want to do everything to get out of it. A debt settlement deal seems to be an appealing choice in this case. From the lender’s standpoint, arranging for partial payment of the existing debt is preferable than getting none. A debt settlement will have an impact on your credit record, but it will allow you to fix issues and rebuild.

Think about the opportunity cost of not paying off your debt. If you do not settle, your score will not suffer immediately. However, failure to settle may result in recurrent late payments, default, and credit-agency collection efforts. In the long term, these events may affect your score more. Debt relief is sometimes the greatest choice, but a clean slate is nearly always preferable.

Consider taxes. The IRS normally treats debt cancellation or forgiveness as taxable income. Consult your tax expert about any potential tax consequences of debt settlement.

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