How Does Debt Settlement Affect Your Credit Score?

The Federal Reserve Bank of New York said Americans have a total credit balance of $887 billion in the second quarter of 2022.

Americans have a total credit balance of $925 billion as of the third quarter of 2022. That’s an $84 billion jump from the first quarter of 2022.

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.

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.

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.

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, these are the two distinct types of scoring models that credit scoring companies can validate statistically.

READ MORE: What credit score do you start with?

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:

  • 730: could drop to 535
  • 630: could drop to 545
  • 505: could drop to 470

As you see, someone with a 630-credit score 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.

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. Settlement

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. 

Will my Credit Score Increase after Debt Settlement?

Not initially, but in the long run, it might.

If you’re considering debt settlement, your score has probably already taken a hit due to missed payments or high credit card balances. 

READ MORE: Why did my credit score drop?

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.”

READ MORE: Debt settlement — Is it the cheapest way to get out of debt?

What Sort of Debts Should I Settle?

Creditors will not settle current debts, mainly if you’ve made your payments on time. You want to pay debts that are seriously past due or have already been turned over to debt collectors. Usually, your credit score falls less as you miss more and more payments.

You should only consider debt settlement if:

  • 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

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.

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

READ MORE: How to deal with debt collectors (when you just can’t pay)

Debt Settlement vs. Staying Current

In your credit history, the most weight is given to payment history so that current accounts 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

READ MORE: How much credit card debt is too much?

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 debt collection laws
  • Regularly monitor your credit reports and check for errors

READ MORE: How to check your credit report and dispute errors

How to Remove Settled Accounts from Credit Reports after 7 Years

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

How Long Will I Have to Wait After Debt Settlement 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.

Tips to Buy a Home After Debt Settlement

  • 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
  • Focus on your debt-to-income ratio:  Get below 43% before approaching lenders. Explain what it is and how to calculate it

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

How Long Does it Take to Improve Credit Score 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.

Tips to Improve Your Credit Score

READ MORE: Best credit repair software

Can I Get a Credit Card after Debt Settlement?

You’ll unlikely get 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

READ MORE: What are the different types of bankruptcy?

The Bottom Line

There are negative consequences to debt settlement. Creditors aren’t guaranteed to agree to settlement offers, and you may receive a lower discount than expected or none. Furthermore, your credit will suffer in the meantime.

As with any debt solution, you must weigh the risks and benefits of debt settlement. However, in all cases, when your debt reaches an unmanageable level, compounding interest makes it hard not to accept debt settlement if you qualify for it.

FAQs

Will I Owe Income Tax on Settled Debts?

You will most likely owe taxes on forgiven or canceled debt. 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. 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.

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