How Does Debt Settlement Affect Your Credit Score?

Credit cards allow you to spend more than you make, and that’s how people quickly find themselves in debt.

If your monthly payments are overwhelming and you’re considering debt settlement, it’s important to understand how the process affects your credit score.

Key Points

  • On average, your credit score will fall by about 100 points
  • 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
  • If you have multiple accounts that are close to the credit limit, those are already hurting your credit score
  • The damage to your credit score will only last until your settlements have been paid
  • 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

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 much it will affect your particular credit score depends on a few more 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.

How Much Debt Are You Trying to Settle?

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

Is the Lender Willing to Negotiate How the Account Status Appears on your Credit Report?

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. Though this won’t directly affect your credit score, it will signal to other lenders (and landlords and potential employers) that 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

Credit Scores Will Increase after Debt Settlement

Yes. It may not be immediate, but as soon as your settlements have been paid — whether as a lump sum or a payment plan, your accounts will be noted as paid and will be closed.

In addition, settling maxed-out accounts will improve your credit utilization, and this will help your credit score.

Pro tip: If you’re considering debt settlement, your score has probably already taken a hit due to missed payments or high credit card balances, so the initial damage from debt settlement may not be as significant as you fear.

Rebuilding your score back to the “good credit” range will probably be slow and 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?

Why Debt Settlement Affects Credit Scores

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.

Pro tip: It’s important to note that creditors have no legal obligation to settle for less (if someone tells you differently, it is almost certainly a scam), and the process will affect your credit score.

For a debt settlement program to work as intended, your creditors have to have incentive to settle. This won’t happen if you’re making timely payments.

This means that before any settlements can be negotiated, you’ll have to stop making your payments until the accounts are charged off (learn more about what that means). This will usually take three to six months of missed payments.

During this time, your credit score will steadily fall as you rack up more missed payments, and will fall up to 100 points when the accounts are finally charged off.

READ MORE: How to choose a debt settlement company

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.

The Damage Won’t Be Permanent

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 repayments are complete, the charge-off notations will be removed from your credit report and your credit card company will close the account due to a contract modification.

At this point, your credit score will start to increase, and should increase further as long as you establish a pattern of making on-time monthly payments on your remaining debts.

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.

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

How to Minimize the Hit to Your Credit Score

On your credit report, the most weight is given to payment history, so keeping accounts current will have the most impact.

Not every debt will be eligible for debt settlement, so it is important to make on-time payments for any accounts that aren’t enrolled in a settlement program.

To minimize the damage to your credit score:

  • Keep newer accounts in good standing
  • Don’t attempt to settle debts that are already 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

READ MORE: Is it better to settle a debt or pay in full?

Which Debts are Eligible for Settlement?

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

Though most unsecured debts are eligible for settlement, there will be a few, including child support, alimony and back taxes, that are not eligible. You also cannot settle secured debts, like home loans and auto loans.

READ MORE: Debt settlement qualifications

Reasons to Consider Debt Settlement

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.

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

Can Debt Settlement be Removed from Credit Reports?

Removing a recently settled account from your credit report is close to 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

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

Make Sure Settled Accounts Have Been Removed from Credit Reports after Seven 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.

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

Tips to Improve Your Credit Score

READ MORE: Best credit repair software

Other Debt Relief Options

READ MORE: What are the different types of bankruptcy?

The Bottom Line

If you’re considering debt settlement, it’s important to understand that your credit score will fall when you begin the process. 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, 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.

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.

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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