Effects Of Debt Settlement On Credit Score

Debt settlement may help your financial situation, but there will be an impact to your credit score.

Debt settlement typically has a negative impact on your credit score. The exact impact depends on factors like the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled and whether your other debts are in good standing.

A debt settlement's impact on your credit score will also depend on much less than the original balance the debt is settled for and other factors.

  • While debt settlement can eliminate outstanding obligations, it can negatively impact your credit score.
  • Stronger credit scores may be more significantly impacted by a debt settlement.
  • The best type of debt to settle is a single large obligation that is one to three years past due.
  • Do not attempt to settle a debt at the expense of falling behind on your other obligations.

Why Debt Settlement Can Ding Your Credit Score

Debt settlement will have a negative impact on your credit score, even though you are reducing your debt obligations.

High credit scores are designed to reward those accounts that have been paid on time according to the original credit agreement before they're closed. A debt settlement plan—in which you agree to pay back a portion of your outstanding debt—modifies or negates the original credit agreement.

When the lender closes the account due to a modification to the original contract (as it often does, after the settlement's complete), your score gets dinged. Other lenders may be reluctant to extend you credit in the future.

Still, it is possible that the reduced debt burden is worth a subsequent drop in your credit score. The high credit card account balances and late or missed payments have likely already lowered your score. If debt settlement jump-starts your path toward a sounder financial future, it should be considered.

Let's examine the debt settlement process in more detail.

Will Paying Off Old Debt Boost Your Credit Score?

How Debt Settlements Work

As you know, your credit report is a snapshot of your financial past and present. It displays the history of each of your accounts and loans, including the original terms of the loan agreement, the size of your outstanding balance compared with your credit limit, and whether payments were timely or skipped. Each late payment is recorded.

You can negotiate a debt settlement arrangement directly with your lender or seek the help of a debt settlement company. Through either route, you make an agreement to pay back just a portion of the outstanding debt. If the lender agrees, your debt is reported to the credit bureaus as "paid-settled."

While this is better for your report than a charge-off—it may even have a slightly positive impact if it erases severe delinquency—it does not bear the same meaning as a rating that indicates that the debt was "paid as agreed."

The best-case scenario is to negotiate with your creditor ahead of time to have the account reported as "paid in full" (even if that's not the case). This does not hurt your credit score as much.

What Type of Debt Should I Settle?

Since most creditors are unwilling to settle debts that are current and serviced with timely payments, you're better off trying to work out a deal for older, seriously past-due debt, perhaps something that's already been turned over to a collections department. It sounds counterintuitive, but generally, your credit score drops less as you become more delinquent in your payments.

However, bear in mind that, if you have an outstanding debt that was sent to collectors more than three years ago, paying it off through a debt settlement could reactivate the debt and cause it to show as a current collection. Be sure to get this straight with your creditor before finalizing any agreement.

A debt settlement remains on your credit report for seven years.

As with all debts, larger balances have a proportionately larger impact on your credit score. If you are settling small accounts—particularly if you are current on other, bigger loans—then the impact of a debt settlement may be negligible. Also, settling multiple accounts hurts your score more than settling just one.

Debt Settlement vs. Staying Current

In your credit history, the most weight is given to payment history, with current accounts having the most impact. If you are behind on other debts, it is important to try first to keep a newer, current account in good standing before attempting to rectify the situation of a long-overdue account.

For example, if you have an auto loan, a mortgage, and three credit cards, and one of those is over 90 days past due, do not attempt to settle that debt at the expense of falling behind on the other obligations. One unpaid account is better than having late payments on multiple accounts.

30%: The average amount of savings a consumer sees after debt settlement, according to the American Fair Credit Council.

This is also going to sound counterintuitive, but the stronger your credit score before you negotiate a debt settlement, the greater the drop in your credit score. The Fair Isaac Corporation, which sets FICO scores, gives a scenario in which a person with a 680 credit score (who already has one late payment on the credit card) would lose between 45 and 65 points after debt settlement for one credit card, while a person with a 780 credit score (with no other late payments) could lose between 140 and 160 points.

How Many Points Will My Credit Score Drop if I Settle a Debt?

The exact impact of a debt settlement on your credit score will depend on factors like the amount of debt. A debt settlement can stay on your credit report for seven years and your score could drop by more than 100 points.

Is it Better to Pay off a Debt or Settle?

Debt settlement is a last-resort option for people who cannot afford to pay their full debt. If you can afford to pay off a debt, it is generally a much better solution than settling because your credit score will improve, not decline. A better credit score can lead to more opportunities to get loans with better rates.

Can Debt Settlement Be Removed From Credit Report?

Once a debt settlement is on your credit report, you cannot have it removed. It will likely stay on your credit report for up to seven years.

Settling an Account Is Better Than Not Paying at All

Although settling an account is considered negative, it won't hurt you as much as not paying at all. And, if you are planning on making a major purchase, such as buying a home, you may be required to either settle or pay in full any outstanding delinquent debts before you can qualify for a loan.

If paying the debt in full is not an option, settling the account is typically more beneficial than letting it go delinquent or, worse, to default.

Settled Accounts Remain on Your Credit Report for Seven Years

When you settle, the account will not be removed immediately from your credit report. If you were late on payments, the account will remain on your credit report for seven years from the original delinquency date.

If the account was positive, meaning there are no late payments in the account history, the account will remain on your report for seven years from the date it was settled.

How to Begin Improving Your Credit Score

If you've had financial troubles in the past, but now you're working to improve your credit, you're on the right track. A good first step is to bring any past due accounts current. More tips for building and maintaining good credit scores include:

  • Make all payments on time going forward. Your payment history—whether you make all payments on time—is the most important factor in credit scores. If you are ever in a situation where you may not be able to make a payment on time, you should contact your lender to discuss your options before the account becomes delinquent.
  • Reduce balances on revolving accounts. The second most important factor in credit scores is your utilization rate—the amount of credit you're using relative to your overall credit limit. If you tend to carry high balances on your credit cards, reducing that debt load will improve your utilization rate.

The Bottom Line

A debt settlement arrangement can be an attractive option to eliminate debt that you cannot pay. However, it will most likely negatively impact your credit report, but it can let you resolve financial strain and start fresh.

Consider the pros and cons of debt settlement in your financial situation, and weigh the alternatives. Also take tax consequences into account and perhaps consult with a professional financial advisor about all your options.