Is It Better to Settle a Debt or Pay in Full?

According to the Federal Reserve Bank of New York, Americans’ total credit card balance was estimated at $925 billion in the third quarter of 2022.

Almost everyone has some debt. But if your debt is overwhelming, holding you back or causing anxiety or depression, you need to find a solution — fast. Debt settlement could be the answer. But is it better to settle a debt or repay it in full?

Table of Contents

Key Points

If you need to protect your current credit score, repaying in full will be your best option
Debt settlement might be best for your finances because you’re repaying less than the total amount you owe
Debt settlement only works if you have a large amount of unsecured debt
You can hire a debt settlement company or try DIY debt settlement

Settling Debts or Repaying in Full: Which is Better?

The short answer is that it depends on your financial situation. What works for you will not be the best strategy for someone else. There are a few key questions to consider, including whether your credit score can withstand the hit and if you expect to need a loan — for a car or other essential purchase — sooner rather than later. If you can afford to take some time to rebuild your credit score before you need to borrow again — or your financial situation is so dire that your only other option is bankruptcy — debt settlement may be the better choice.

READ MORE: Debt settlement qualifications

Can You Afford the Hit to Your FICO Score?

There are two ways debt can appear on your credit report.

Paid in Full
Settled in Full

Pro tip: Settled in Full is not the same as a charge-off. To learn more about those, check out What is a charge-off?

In both cases, your balance will be zero, and your account will be closed. Each option, though, will impact your credit score differently. It is essential to understand the distinctions.

Paid in Full will be Better for Your Credit Score

Paid in full means that the entire balance of your debt, including any interest, has been completely paid off. Paid in full is your best option and positively affects your credit score more than on-time payments.

Repayment in full is an option even if your account is past due. It shows lenders that you’re able to fulfill your obligations. It will always be better for your credit score to pay in full.

A paid-in-full designation will only help your credit score. On-time payments are a vital component of your credit score, so keeping your accounts in good standing is essential. On-time payments stay on your credit report for up to 10 years.

Pro tip: One thing to consider is that if your debt is truly overwhelming, your credit score likely has already taken a pretty big hit. If that’s the case, another hit likely won’t make much difference.

Settled in Full May be Better for your Financial Situation

When an account is marked as “settled in full,” you pay off your debt for less than the total amount you owe.

You negotiated an agreement with a lender, creditor, or debt collector to pay a lower amount, and your debt is satisfied. Paying your debt could involve either a payment plan or a lump-sum payment.

Pro tip: Some experts will tell you that having “settled in full” on your credit report will harm your credit score for up to seven years. This isn’t actually true. Once you’ve paid your settlement, your account will be closed and noted as “settled” but that designation doesn’t hurt your credit score. Once your settlements are paid, your credit score will likely increase.

You will not be able to get the three credit bureaus to remove a “settled” designation from your credit report unless it is truly an error. It will remain on your credit history for up to seven years and potential employers and landlords will be able to see it.

However, sometimes paying the entire balance is not an option, and a “settled” account is better in lenders’ eyes than defaulting or filing bankruptcy. It is also usually better to have “settled” debt listed on your credit report than to carry a large amount of debt, which will hurt your debt-to-income ratio.

When Should I Settle a Debt?

Sometimes you lose control of your debt and must get your finances back on track. Ask yourself these questions:

Do you have more than $10,000 in unsecured debts?
Can you show you’re facing financial hardship?
Are lenders or debt collection agencies hounding you?
Is your mental health suffering because of your financial situation?
Are you racking up late fees from multiple late payments each month?
Is your credit score already low enough that you won’t qualify for a debt consolidation loan or balance transfer credit card?

READ MORE: Best debt settlement companies

How Debt Settlement Works

You can contact credit card companies to make a settlement offer or hire a debt settlement company.

Settling debts is usually only an option for unsecured debt, including:

Credit card debt
Personal loans
Debt consolidation loans
Medical bills
Student loans
Even the IRS is willing to settle some tax debts

However, the settlement will not work for most secured debts, like home or auto loans.

What’s the right move when you’re being hounded by a collection agency? To learn more, check out this video:

Debt Settlement Options

You have two options: hire a debt settlement company or do it yourself.

Hire a Debt Settlement Company

A debt settlement company will negotiate on your behalf but will charge a hefty fee for that convenience. The company also will want you to deposit monthly payments into an escrow-like account. The company will use that money to pay the settled charges in a lump sum. They may also ask you to stop making regular payments to your lender or creditor, which will hurt your credit score. Also, no creditor is guaranteed to settle even if you hire a professional company.

While plenty of legitimate debt settlement companies exist, the industry is full of scams and fraudsters. Research any company before you give them any money. 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 a fee upfront. If this happens, cease all contact and file a complaint with the Consumer Financial Protection Bureau (CFPB), the Federal Trade Commission (FTC) and the attorney general’s office for your state.

DIY Debt Settlement

With this method, you will call your creditors and negotiate. DIY can be an excellent way to save money, but you’ll need patience and negotiating skills.

Know the tax consequences: The IRS counts settled debts as taxable income, so you’ll probably have to pay taxes on any forgiven debts come tax time. For example, if you owe $10,000 and settle for $5,000, the $5,000 you don’t have to pay will be taxable.

The Federal Trade Commission offers some debt settlement advice here: https://consumer.ftc.gov/articles/settling-credit-card-debt.

READ MORE: How to pay off debt in collections

Debt Settlement Alternatives

Call your creditor and renegotiate
Apply for forbearance or deferment
Do you qualify for loan forgiveness?
Try debt consolidation
Talk to a nonprofit credit counselor about a Debt Management Plan

The Bottom Line

Being in debt is never fun. While repaying your debts in full will be the better option for your credit score, debt settlement can be the lifeline you need in order to get your financial situation back on track.

Debt settlement may be a setback in the short run, but it could be a fresh start and offer an opportunity to repair your past mistakes.

The key is to make an informed decision, and discipline is essential once you choose your path. You’ll need to stay organized, make your payments on time and create a realistic monthly budget to get you out of debt within whatever timeframe works for you.

FAQs

What is a Charge-Off?

A charge-off is when a legitimate debt is where the lender has stopped trying to collect from you. It typically happens after six months of them trying to collect from you, it is a delinquent debt, and the creditor has written off this debt as a loss. You are still legally responsible for the debt, and an unpaid debt listed as a charge-off will remain on your credit report for up to seven years.

What is Credit Utilization, and How is It Calculated?

Credit utilization is similar to calculating the loan-to-value ratio, but it deals specifically with the sum of all your credit card balances. Let’s say you have two credit cards with credit limits of $1000 each. One card has a $500 balance, and the other has $250. So, you have $750 in outstanding debt. Divide this by $2000, and you have a credit utilization ratio of 37.5%. Your credit utilization should be 30% or less.

How Can I Find a Legitimate Nonprofit Credit Counseling Agency?

Debt management plans are administered by a nonprofit credit counseling agency that negotiates with your lender in lowering the interest rates to help resolve your debt. You still pay the total amount of the principal, so your credit score won’t fall as much as it would with debt settlement. Don’t miss a payment, or the creditors will nullify any concessions you had.
To identify a reputable counselor, ensure they are accredited by a reputable organization, such as the NFCC or the Financial Counseling Association of America (FCAA).