How Does Debt Settlement Affect Your Credit Score?

Americans owe a total of $925 billion in credit card debt as of the third quarter of 2022. That’s an $84 billion jump from the first quarter.

Credit cards allow you to spend more than you make, so that’s why people quickly get into debt. If your debt has you in a pickle, read along to learn how debt settlement will affect your credit score.

Table of Contents

Key Points

Debt settlement gets you out of debt while paying less that the total amount you owe
Settling a debt will hurt your credit score, but only until you’ve paid off your settlement
It will take between six to 24 months to rebuild your credit score after settling your debts
If you need debt settlement, your credit score is probably already on the lower end, so the impact won’t be as bad as you fear
Borrowers with the highest credit scores will see the highest negative impact — someone with a 700+ credit score could see a decline of up to 200 points.

Why Does Debt Settlement Impact Credit Scores?

As the original credit agreement specifies, good credit scores reward borrowers who pay their accounts on time.

Debt settlement involves negotiating with your creditor to pay less than the total you owe. You can call the creditor directly and negotiate or hire a third-party company to negotiate on your behalf. Virtually any unsecured debt can be settled, including many private student loans. However, creditors have no legal obligation to settle for less (and if someone tells you differently, it is almost certainly a scam), and it will affect your credit score.

In a debt settlement plan — where you agree to pay back a portion of the debt you owe — you are modifying or negating your original contract.

Because of this, debt settlement dings your credit score. After the payment is complete, your credit card company will close the account due to a contract modification. And other lenders will notice.

Pro tip: How much it will affect your credit score will depend on your current credit score. If you’re considering debt settlement, it’s probably already on the lower side, so the impact may not be as bad as you fear. It may only fall by 25 to 50 points. However, if your score is relatively high (700+), the damage will likely be more significant, and you could lose up to 150 points.

However, the damage won’t be permanent.

Once you’ve reached a debt settlement agreement and re-establish a pattern of on-time monthly payments, your credit report will reflect that, and your score will start to increase.

READ MORE: How to get a free credit score

How Your Credit Score Works

A credit score is designed to assess your creditworthiness. The most popular model is the FICO score. The VantageScore model was also introduced in 2006 when the three major credit reporting bureaus — Experian, Equifax, and TransUnion – offered FICO some competition in the credit score business.

There are “base” FICO Scores used by lenders in multiple industries, plus industry-specific credit scores for credit card issuers and auto lenders. Your credit score usually won’t fall below 300.

The base FICO scores range from 300 to 850.

Ranges are:

Exceptional credit: 800 to 850
Very good credit: 740 to 799
Good credit: 670 to 739
Fair credit: 580 to 669
Bad credit: 300 to 579

While several credit scoring models are utilized to determine a person’s creditworthiness, FICO and VantageScore are the two most recognized scoring models that credit scoring companies can validate statistically.

How Far Will Settling Credit Card Debt Knock Down Your Score?

Debt settlement will impact your score differently based on your starting score. Borrowers with the highest credit scores will see the highest negative impact.

For example, here is the estimated impact based on the FICO score:

If your current score is 730, it could drop as low as 535
If your current score is 630, it could drop to 545
If your current score is 505, it could drop to 470

As you see, someone with a credit score of 630 could settle a debt and end up with a higher credit score than a borrower whose score started at 730.

How it will affect your particular credit score depends on a few factors.

READ MORE: Best debt settlement companies

Are All of Your Other Accounts in Good Standing?

What are the reporting practices of your creditors, and if they have any? Some payday lenders, for example, don’t report to credit bureaus, while some report to only one bureau and others to all three. All of this will affect your credit score.

What’s the Total Debt Being Settled?

The bigger the debt balance you settle, the bigger the hit will be to your credit score.

Account Status on Credit Report: Paid in Full vs. Settled

How the debt payment is classified on your credit report will affect your credit score. If you’re worried about your score, it is possible to negotiate that a settled debt be reported as paid in full.

Paid as settled: When your debt settlement program is complete, creditors will mark your debt on your credit report as “paid as settled.” Paid as settled indicates that you repaid less than you borrowed. It will push down your credit score because you didn’t fulfill the terms of your borrowing contract.
Paid in full: This means you’ve paid your account as agreed. Paid in full will not hurt your credit score as much as a “paid as settled” notation, though your score might go down slightly because the paid debt will affect your debt-to-income ratio.
Charge-off: This indicates that you did not repay the debt. If a loan is marked a charge-off, you are still obligated to repay the total.

READ MORE: Pros and cons of debt settlement

Do Credit Scores Increase after Debt Settlement?

Not initially, but in the long run, it likely will. If you’re considering debt settlement, your score has probably already taken a hit due to missed payments or high credit card balances. Once your budget is stabilized and you’re once again able to make your payments on-time on a regular basis, your score will steadily begin to increase. It will be slow and will require some patience. But the advantages of debt settlement could outweigh the benefits of a high credit score, particularly if you already own a home. You want to be able to protect the assets you already have.

READ MORE: Why did my credit score drop?

How Long Does it Take to Improve Credit Scores After Debt Settlement?

It will take between 6 to 24 months to rebuild your credit score, depending on where it was when you settled your debts.

How Debt Settlement Works

Debt settlement is an agreement with your creditors to accept a lower payment total. You can contact your lender directly to ask for a settlement or hire a debt settlement company. You agree to pay back a portion of your remaining debt with either option. At that point, your debt will be reported to the three major credit bureaus as “paid-settled.”

What Sort of Debts Should I Settle?

Creditors will not settle current debts, particularly if you’ve made your payments on time. You want to settle debts that are already seriously past due or have been turned over to debt collectors.

READ MORE: Debt settlement qualifications

You should consider debt settlement if you’re facing one or more of these situations:

You’re facing a significant hardship
You have a higher-than-average amount of unsecured debt
You have at least one unsecured debt that is 90 days past due
You’re willing to commit to a long-term plan to repair your finances
You don’t mind the impact on your credit score
You don’t want to file for bankruptcy

READ MORE: Debt settlement fees

Pro tip: If your debt was sent to collectors more than three years ago, paying it off — even as a settlement — could reactivate your debt. If that happens, it would show as a current collection and hurt your credit score more. You will need to discuss this with creditors before reaching an agreement. If you aren’t certain how to proceed, it’s best to consult with a professional debt relief company. You don’t want to do anything that would unintentionally worsen your financial situation.

Debt Settlement vs. Staying Current

On your credit report, the most weight is given to payment history, so keeping accounts current will have the most impact. Because of this, it’s more important to keep up with your existing accounts. Don’t worry so much about a charge that is already more than 90 days past due.

To minimize the damage to your credit score:

Keep newer accounts in good standing
Don’t attempt to settle debts that are several years past due
Remember that one unpaid bill will hurt your credit score less than multiple late payments on different accounts
Don’t be afraid to consult a professional for guidance

Can Debt Settlement be Removed from Credit Reports?

Removing a recently settled account from your credit report is impossible. The Fair Credit Reporting Act requires creditors to report information accurately. If the negative information on your report is correct, there’s nothing you can do except wait.

There are some steps you can take to protect yourself, though:

Verify that your credit reports have been updated as soon as your seven years are up
Get written proof of your settlement and make sure it’s dated. Written confirmation of your settlement will help if a creditor or collection agency tries to (illegally) make it seem like your delinquency is more recent
Keep up-to-date on the latest debt collection laws
Regularly monitor your credit reports and check for errors

How to Remove Settled Accounts from Credit Reports after 7 Years

If, after seven years, the settlement still appears on your credit report, you’ll need to file a dispute with the credit reporting agency (Experian, Equifax or TransUnion). Submit what is wrong and why in writing, and include a copy of your dated settlement agreement.

You’ll Probably Have to Wait a Bit Before You’ll Be Able to Buy a House

It’s unlikely that you’ll be able to buy a house immediately after debt settlement. But you won’t necessarily have to wait seven years for the settlement to fall off your credit report, either. You’ll have to be patient and strategic.

How to Buy a Home After Debt Settlement

If you are mulling debt settlement, you likely aren’t in a position to immediately purchase a home. However, you won’t necessarily need to wait as long as you might think. Here are a few ways to boost your odds:

Save for a 20% down payment
Improve your credit: Pay your existing debts on time and lower your credit utilization ratio. These two components account for 65% of your score
Consider a rent-to-own property
Focus on your debt-to-income ratio: Get below 43% before approaching lenders

Pro tip: To calculate your DTI ratio, divide your total monthly debt payments (including credit cards, loans, mortgage, etc.) by your gross monthly income (before taxes and other deductions). For example, if your monthly debt payments are $1,500 and your gross monthly income is $5,000, your DTI ratio would be 30% (1,500 / 5,000 x 100).

To learn more about the pros and cons of debt settlement, check out this video:

Tips to Improve Your Credit Score

Pay all bills on time.
Sign up for a credit-builder loan
Consider a credit repair service (Experian Boost is an excellent free option)
Use your subscriptions to build credit
Don’t close any existing credit card accounts.

READ MORE: Best credit repair software

Can I Get a Credit Card after Debt Settlement?

It is unlikely that you will be approved in the immediate months after a debt settlement. How long you’ll have to wait depends on your credit score before and after the settlement period. Your best options would be:

A secured credit card
Become an authorized user on someone else’s account

Another key question will be whether you can handle new credit. Do you have the discipline and. means to ensure that your bills are paid on time? If not, you run the risk of making the damage worse.

READ MORE: Best secured credit cards

Other Debt Relief Options

The Bottom Line

There are negative consequences to debt settlement. The biggest is likely the impact it will have on your credit score. However, depending on your financial situation, it could very well be worth dealing with a lower credit score in order to break free from debt.

And nothing is permanent. As long as you complete your debt settlement agreement and follow through with good financial habits in the future, eventually your credit score will rebound and you’ll be back on track.

FAQs

Will I Owe Income Tax on Settled Debts?

The IRS usually counts settled debts as taxable income. The forgiven debt is the difference between what was owed on the debt and what the actual settled amount was. Whether the canceled debt amount is treated as taxable income will depend on several factors such as the type of debt, the debtor’s financial situation, and whether any exceptions or exclusions apply. It’s best to consult a tax attorney before finalizing any agreement.

How Can I Learn if a Debt Settlement Company is Legitimate?

The most obvious sign of a debt relief scam is if the person or company offers to help get rid of your debt by first paying them an upfront fee. Cease all contact and file a complaint with the Consumer Financial Protection Bureau, the Federal Trade Commission, and your state attorney general’s office.

How Can I Get a Free Credit Report?

Your payment histories, credit balances, or any movement in your credit history gets reported to the big three credit reporting companies: Experian, Transunion, and Equifax.
These reports determine your eligibility and worthiness as a borrower and dictate the loan rates, amounts, and terms. Pull a free credit report from all three credit bureaus.