Credit Repair

How Debt Settlement Affects Your Credit

Debt settlement is a process offered by companies to renegotiate or “settle” your debt with various lenders, such as credit card issuers.

According to the Federal Trade Commission (FTC), debt settlement programs “typically are offered by for-profit companies, and involve the company negotiating with your creditors to allow you to pay a ‘settlement’ to resolve your debt. The settlement is another word for a lump sum that’s less than the full amount you owe.”

Debt settlement is an alternative to debt consolidation, which involves a loan that is used to pay off higher-interest debts. The rate on the consolidation loan will be lower than the rates on the debts to be paid off. Debt consolidation loans are still loans and don’t reduce your debt. Debt settlement generally allows you to reduce your debt as part of the settlement process.

How debt settlement can impact your credit

It’s important to understand how debt settlement companies work and the impact that debt settlement might have on your credit report.

Debt settlement hurts your credit score

“Debt settlement will impact your credit, no doubt about it,” said Gerri Detweiler, education director at credit-monitoring company Nav. “That’s because creditors won’t settle for less than the full amount unless you’ve already fallen behind. For it to be effective, you must stop paying your creditors.”

By the time most consumers even consider debt settlement, they are likely already in deep financial debt, Detweiler said, adding that if you have high balances on your credit cards or a spotty payment history, this has already had a negative effect on your credit score.

While settling an account is favorable to not paying on it at all, it is still viewed as a negative on your credit report.

Settled accounts may stay on your credit report for 7 years

An account that was settled will show up on your credit report with a status of “settled.” This entry will appear for seven years from either the date the account first went delinquent or the date of the settlement, depending on the situation.

Impact of missing payments

Most debt settlement companies require you to stop making payments on your debt while they work with the creditors to settle the amounts. This will likely bring your credit score down because payment history is typically the most important factor in determining your credit score. Make sure you work with a debt settlement company that is reputable since you are taking a risk by stopping payments on the accounts.

“Consumers should be extremely cautious when using a debt settlement firm,” said Lori Stratford of Navicore Solutions, a nonprofit National Foundation for Credit Counseling agency based in Manalapan Township, N.J. “Most of these agencies require payments be made to them, while the bills continue to fall further behind.”

Avoid any debt settlement agency that charges fees prior to the creditors agreeing to the settlement, Stratford advised.

“There is no government plan that requires creditors to settle debt, so if promises like this are made or advertised, stay away from that agency,” she said. “Make sure you have everything in writing.”

The FTC echoes that warning: “Debt relief service scams target consumers with significant credit card debt by falsely promising to negotiate with their creditors to settle or otherwise reduce consumers’ repayment obligations. These operations often charge cash-strapped consumers a large up-front fee, but then fail to help them settle or lower their debts — if they provide any service at all.”

There may be tax consequences

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

Why debt settlement may still 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 time. It may take seven years or more, but it will happen if you can show you are a responsible borrower by doing things such as paying on time, not going further in debt and keeping your balances on your credit cards within a reasonable level.

“In the end, you will be out of debt and will have cash flow, which is needed to be financially healthy,” said Leslie Tayne, a New York-based financial debt resolution attorney and author of “Life & Debt.” “We often have clients tell us their score came up considerably even when they aren’t done with the program.”

Detweiler echoed that advice: “My suggestion is to think about where you want to be in three to five years. Would you rather be out of debt and rebuilding your credit, or still struggling with your debt?”

(LendingTree has information available if you need help from credit repair services.)

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 the credit card company or other lender.

You could pay less

“You will not have to pay the entire balance of what you owe,” Stratford said. Depending on the difference between the amount of the debt and the amount of the settlement, this can result in considerable savings for you.

You may avoid bankruptcy

“The damage from debt settlement can be on the equivalent to the damage from bankruptcy; one key difference is that bankruptcy is a matter of public record while your personal credit reports and scores have restricted access,” Detweiler said.

The bottom line

Debt settlement can be a viable option and an alternative to bankruptcy if you find yourself deep in debt.

Make sure you thoroughly vet any debt settlement firm and evaluate all options before choosing this route. For those deeply in debt, the potential risks may well be worth it. Be sure to look at all options to reduce your debt before deciding on debt settlement.

 

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