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How Debt Settlement Affects Your Credit

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Before committing to debt settlement, you may be wondering: “How much does debt settlement affect your credit score?”

Debt settlement is a process offered by companies to renegotiate or “settle” your debt with various lenders, such as credit card issuers. Debt settlement companies are typically for profit. They negotiate with your creditors on your behalf to come to an agreement as to how to close your debt for a lump sum that’s less than the current amount you owe.

How debt settlement affects your credit

While settling an account is better than not paying it at all, it can still hurt your credit history. Keep the following in mind:

Settled accounts may stay on your credit report for up to seven years

An account that was settled remains on your credit report with a status of “settled.” This entry will appear for seven years from the date the account first went delinquent.

Like with declaring bankruptcy, this could potentially make it challenging to get approved for obtaining credit for some time.

Missing payments while your debt is settled will ding your credit score

Most debt settlement companies require you to stop making payments on your debt while they work with creditors to settle the amounts. This is because some creditors may not settle for less than the full amount unless you’ve already fallen behind on your payments.

If you stop paying your creditors, however, this can bring your credit score down because payment history is one of the most important factors when determining your score.

By the time most consumers even consider debt settlement, they are likely already in deep financial debt. Therefore, it’s possible you may already be missing payments.

Make sure you work with a debt settlement company that is reputable since you are taking a risk by stopping payments on the accounts.

Fees can stack up with no guarantee your debt will be reduced

There are certain risks that may come with working with a debt settlement company.

Debt settlement agencies may require you to make payments for three years or more before your debts are settled. Be sure to review your budget before agreeing to work with a debt settlement company so you don’t end up quitting the repayment program.

Debt settlement companies may try to settle smaller credit accounts first, which can cause fees and interest to stack up on your larger debts.

You may have to pay taxes on your settled debts

Credit card companies and other creditors may report debt settled for less than the full amount to the IRS. Depending on the type and amount of debt, you could then potentially be liable for taxes on the difference, as the IRS considers this to be taxable income.

How debt settlement works

When it comes to debt settlement, you can work with a company to negotiate on your behalf or you can work with your creditor yourself.

To work with creditors yourself, you’ll need to contact your creditors and explain your financial situation. You may need to be patient but determined during this process, and you’ll want to continue making payments to your creditors. If you choose to go through a debt settlement company, it will work on this process for you, though your creditors may not be willing to work with your debt settlement company.

You can start by offering to pay a certain amount of cents for every dollar you owe. For example, you can begin the bargaining by offering to pay 25 cents on the dollar, then 50 cents and so on until you agree on a settlement. Or you could negotiate a payment plan or lump sum settlement.

In some cases, your creditors may not be willing to settle if they believe you can still pay the full amount of your loan. They may prefer to wait until your accounts are in default. However, you could meet in the middle with your creditor in the meantime to reduce your interest, eliminate fees and/or decrease your minimum monthly payment.

If you’re unsure about whether debt settlement is the right choice for you, consider other options such as debt consolidation, which pulls together all your debt into a single loan.

Which debts should I settle?

Because creditors are less likely to settle debts that are current or just delinquent, it may be best to approach creditors about old, past-due debts, especially ones that have been turned over to a collection agency. Creditors may be more willing to work with you on these types of debts.

You may also want to address your largest debts first, as these could be hurting your credit score more than your smaller debts.

  If you’ve defaulted on your debt: If you’re more than 180 days behind on your payments, your creditor has likely reported your account as “default” to the credit bureaus and sold your debt to a collection agency. If you’re still unable to pay and want to avoid bankruptcy, you may be able to settle your debts for less than you originally owed and avoid some fees.

  If you’re delinquent on debt: Delinquent debt is considered to be between 30 and 90 days late. At this point, your creditor may not be willing to negotiate a debt settlement.

  If you haven’t missed any payments: If you haven’t missed any payments, it’s unlikely your creditor will be willing to settle your debts. It’s best to keep up with your minimum monthly payments and pay down the balance by as much as you can afford.

Why debt settlement may be worth it

For all of the potential negatives of debt settlement, it still might be worth doing.

Your credit score should recover

While your credit score will likely take an initial hit, it should recover over several years. It will happen faster if you can show you’re a responsible borrower by doing things such as paying on time and not using too much of your credit limit.

A settled account is better than a defaulted one

A settled account is viewed more favorably than one that has been defaulted on and written off by a credit card company or another lender.

You could pay less

If you’re successful in your settlement ventures, you’ll end up paying less than what you originally owed. This can free up your cash flow as well as allow you to build up your savings or pay down other debts.

You may avoid bankruptcy

While debt settlement and bankruptcy, specifically Chapter 13 (aka the “wage earner’s plan”), have some similarities, one of the biggest differences is that bankruptcy is a matter of public record. On the other hand, your credit report and score are more personal.

The advantage of bankruptcy, however, is that some forms (such as Chapter 7) allow borrowers to completely eliminate their debt.

How to spot debt settlement scams

If you’re searching for a debt settlement company to work with, beware of predatory debt relief scams that target consumers with large amounts of debt.

Per the Federal Trade Commission, you’ll want to watch out for the following red flags:

  • Requires that you pay fees up front before negotiating with your creditors
  • Claims it is working with a “new government program”
  • Makes guarantees up front
  • Advises you to stop all communications with your creditors and doesn’t explain the impact that can have on your case
  • Promises it can stop all lawsuits and collection calls
  • Asserts that debts can be settled for very cheap

If you want to avoid scams, consider instead working with a credit counseling organization. You can find a list of reputable credit counseling agencies on the Department of Justice’s website.

Frequently asked questions

Because creditors report debt settlement to the credit bureaus, it can indeed have a negative impact on your credit score and can stay on your credit report for years to come. However, chances are, even before your debt was settled, your credit score likely took a hit from missed payments.

While your credit score may suffer for a bit when you first settle your debt, your credit score can eventually go up over time. After you settle your debt, it’s important to be intentional about rebuilding your credit by making sure you keep your credit use low and making on-time payments.

Similar to Chapter 7 bankruptcy, debt settlement can stay on your credit report for up to seven years. While this may seem like a long time, the impact of this event on your credit report will lessen over time. Your credit score can improve as long as you are making wise financial decisions and being intentional about rebuilding your credit.

 

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