Debt settlement companies offer to help clear your outstanding debts by negotiating a smaller amount than you actually owe. 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 how much the debt is settled for compared to the original balance and other factors.
Key Takeaways
- Debt settlement can eliminate outstanding obligations, but 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.
- Don't attempt to settle a debt at the expense of falling behind on your other obligations.
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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 credit score gets dinged. This is partially because you no longer have as much credit available to you, which reduces your credit utilization ratio. In some cases, it may also be a result of reducing your credit mix. No matter what, an involuntarily closed account is a black mark on your credit report. Other lenders may be reluctant to extend you credit in the future.
Still, the reduced debt burden may be 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.
How Debt Settlements Work
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 good debt settlement company. Through either route, you'll 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."
Debt settlement is generally better for your report than a charge-off because it may even have a slightly positive impact if it erases severe delinquency. However, it doesn't have as good of an impact on your credit as if the debt was paid in full as agreed.
If you settle a debt, the amount that is forgiven may be considered taxable by the Internal Revenue Service (IRS).
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 in a process called re-aging. Be sure to get this straight with your creditor before finalizing any agreement.
A debt settlement can remain 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. Additionally, 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 greatest impact. If you are behind on other debts, it's important to try first to keep a newer, current account in good standing before attempting to resolve 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, don't 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.
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 several factors, such as the amount of debt. A debt settlement can stay on your credit report for seven years, and your score could drop by over 100 points.
Is It Better to Pay Off a Debt or Settle?
Debt settlement is one of the last-resort options for people who cannot afford to pay their full debt. If you can afford to pay off a debt, it's generally a much better solution than settling because your credit score will improve, rather than 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.
How Do I Select a Debt Settlement Company?
The best debt relief companies charge reasonable fees, have strong customer service rankings, and are free of regulatory actions from agencies like the Consumer Financial Protection Bureau (CFPB) and Federal Trade Commission (FTC).
The Bottom Line
A debt settlement arrangement can be an attractive option to eliminate debt that you cannot pay and can help you resolve financial strain and start fresh. However, debt settlement will most likely negatively impact your credit report. Consider the pros and cons of debt settlement in your financial situation, and weigh the alternatives. Additionally, take tax consequences into account and perhaps consult with a professional financial advisor about all your options.
