Credit Card Settlement and Your Credit Score

The amount of debt you have and whether you ever engaged in a credit card settlement are two major factors that affect your credit score. If you want to get and maintain a high credit score, one thing is always true: Pay off your debts … on time!

Paying off the money you owe leaves no lasting dings on your score, although if you take too long to do it you probably will see a small initial drop in your score. Going through debt settlement becomes a serious negative mark on your credit history, one that will drop your credit score and affect how you borrow money soon.

Going through debt settlement means you didn’t pay off your debts in full at the time they were due. It results in a lower credit score and reflects poorly on your credit report, where the settlement remains for seven years from its delinquency date.

Paying off your debt in full shows you cared about completing your financial obligation in full and on time.

What Happens to Your Credit When You Settle Your Credit Card Debts?

When you settle your credit card debts, it gives you a chance to reset, reorganize your finances and rebuild your credit score. But debt settlement usually stems from being severely delinquent or already in default, which can lower your credit score 100 points or more.

Missing payments and then charging off (defaulting) on debt can lower your credit score by more than 100 points even before the debt settlement process starts. Overall, the process can be time consuming and emotionally taxing. Although it ultimately provides financial relief, it also exposes you to additional interest and late fee charges from the lender; fees from debt settlement agencies; and taxes from the Internal Revenue Service.

How much debt settlement affects your credit rating depends on where you are financially at the time: whether you’ve already defaulted on an account or if you’re delinquent. An account typically becomes delinquent if you don’t make a payment within 30 days of the due date. If you miss several payments in a row and the lender decides that you won’t pay again, the account is classified as being in default.

The specifics of when an account moves from being delinquent to being in default differ by loan terms and lenders. Some credit card debt may be considered in default if it one day past the due date, but typically, it’s six months from the due date

Creditors rarely report a delinquency to the credit bureaus immediately (for up to 30 days). But they may charge a late payment fee. If you fall further behind on your payments, your credit takes more of a hit. When the account goes into default, a debt settlement won’t minimize any credit score damage. A record of your default will remain on your credit reports for seven years.

While debt settlement definitely has its benefits, it also has its downsides. Let’s look at some pros and cons of debt settlement.

Debt Settlement Will Most Likely Hurt Your Credit Score

Debt settlement is likely to lower your credit score by as much as 100 points or more. But it’s impossible to say exactly how many points your credit score will drop because of settling the debt because the decline depends on multiple factors.

Having a large debt balance has a proportionately larger impact on your credit score. It’s counterintuitive, but people with an initial high credit score suffer a greater drop on their credit score because of a debt settlement than people with a lower initial score. And the more you fall behind, the more your credit score will fall. However, it is important to remember that the most weight in your credit history is given to the payment history of current accounts.

Oddly, at some point your score drops less as you fall further behind in your payments. It’s more important for you to catch up on current accounts than to pay off old accounts.

Settled Accounts Can Stay on Your Credit Report

Once your debt settlement information gets reported to the credit bureaus and it accurately reflects your financial history, it’s difficult to get it removed from your credit report. As mandated by the Fair Credit Reporting Act, details of settled accounts stay on credit reports for seven years from the first delinquency that led to the settlement.

But that’s not ironclad. Lenders have discretion in reporting debt settlement information to credit bureaus. In fact, there’s no legal requirement for lenders to report this information. As a sign of goodwill to long-standing clients or as part of internal reporting policy, they can choose not to report it as part of a negotiated agreement with the borrower during the debt settlement process.

Regardless, the fact remains that it settled your debt and has the right to keep a record of it. Future potential lenders may request information on your complete credit history, including debt settlements during their credit evaluation process.

You Could Have to Pay Taxes on Your Settled Credit Card Debt

Sometimes taxes come into play with a debt settlement. If the amount of the debt that gets forgiven is $600 or more, the IRS treats it as money received and requires the creditor to send you (and the IRS) a form 1099-C as documentation for taxable income.

This makes you responsible to report the income on your annual tax return. Calculating the exact tax implications can be complex. You would be smart to consult an accountant or a tax professional for specific advice.

Missing Payments Will Hurt Your Score

Your payment history is one of the most important factors that determines your credit score. Lenders like to see a long, consistent history of on-time payments in every aspect of your financial life, from mortgages, rent, vehicle loans, student loans, etc.

Some debt settlement agencies will ask you to pause your debt payments while they work with lenders to settle the debt. The reason? Some lenders won’t negotiate a settlement unless you’re missing payments. The downside, of course, is that some lenders might report these missed payments to credit bureaus, thus lowering your credit score and denting your credit report.

If you think you’re going to have trouble making future payments, be proactive and be honest. Call one or more creditors and tell them what’s going on. They might give you new payment terms or a repayment plan.

Think about working with a credit counseling agency to help you with a debt management plan that puts your debt into one consolidated monthly payment.

Another possibility is securing a debt consolidation loan that has an interest rate lower than your credit cards. This can make your payment sizes easier to handle every month.

A nonprofit credit counseling agency can give you insight into how debt management works. If all else fails, bankruptcy would give you a new start, although it comes with long-term financial ramifications. One thing to keep in mind: get financial advice from a professional before committing to any of these alternatives. There are pros and cons to every move. Learn them and weigh them.

Credit Card Settlement Can Help Your Credit Score in the Long Term

While it may initially lower your credit standing, a credit card settlement can help you regain a good credit score. It will take time as you follow a methodical plan. You can improve your debt-to-income ratio, which then raises your credit score and credit worthiness. Paying off delinquent accounts will also improve your credit score. Once you settle your debts, you can rebuild your credit armed with your new financial knowledge.

Going back to using credit again and opening new lines after credit card debt settlement can be intimidating. As for how long you should wait, there is no specific timeframe. However, it is important to take some time to stabilize your financial situation, rebuild a solid financial foundation and show responsible credit management. Rebuilding credit takes time and effort. Several months or as long as you have established a stable financial footing should be okay.

How to Rebuild Your Credit After Credit Card Settlement

A credit card debt settlement only gives you the chance to reset, reorganize and rebuild your finances. After that, you must invest time, effort, and discipline to make it worthwhile. Here are a few tips to rebuild your credit:

• Pay your bills on time — all of them.
• Don’t live on credit — try only to use less than 30% of your available credit.
• Use secured credit cards to build positive payment history.
• Use a variety of credit (loans, credit cards, lines of credit, etc.). You want to prove your ability to manage many types of debt.
• Review your credit reports from all three major credit bureaus (Equifax, Experian, and TransUnion). Be diligent about reporting discrepancies and errors.
• Practice sound financial habits and trust the process. It works.
• Consult credit counselling agencies or financial professionals for personalized advice on how to manage your credit.

Should You Settle Your Credit Card Debt?

Settling credit card debt depends on your specific situation. This form of debt relief allows you to clear your debts and reorganize your finances, but the downsides – fees for services, late fees for failure to make payments, interest charges on amount owed and damage to credit score – could make it a costlier decision that you realize. This is a personal decision that requires careful consideration about where you are financially vs. the plusses and minuses associated with debt settlement.

If you’re unsure about any of it, consult a nonprofit credit counseling agency. And weigh all your options.

At InCharge Debt Solutions, our debt relief services include debt management, credit counseling and financial education resources. Our highly trained and certified team of financial experts will provide you with the personalized help you need to navigate the complexities of credit card debt settlement and help you develop a plan to regain control of your finances. We look forward to helping you pave the way towards financial stability and a brighter future.