Does Debt Settlement Hurt Your Credit?

Debt settlement can have a negative effect on your credit. How bad will it be? It’s impossible to predict the exact number of points you’ll lose, or when you’ll be able to get approved for financing again since several factors come into play.

One thing is certain: negative activities associated with debt settlement — like missing a credit card payment or having a debt charged off — will hurt your credit score and stay on your credit reports for seven years.

Yes, that’s a long time to wait, but fortunately, there are ways to improve your scores in the meantime.

What Is Debt Settlement?

Debt settlement is a financial strategy where a borrower negotiates with their creditors to pay a portion of the debt owed, typically in a lump sum, to resolve the outstanding balance. The creditor agrees to accept this reduced amount as full payment, forgiving the remaining debt. Debt settlement is often pursued when the debtor cannot afford to make the full payments on time and risks defaulting. This process is often facilitated by a debt settlement company or a lawyer who negotiates on behalf of the debtor, though individuals can negotiate directly with creditors.

People choose debt settlement to resolve unpaid debt for several reasons. One of the primary motivations is financial relief. Debt settlement also helps avoid more severe alternatives like bankruptcy. Additionally, debt settlement can offer a faster route to financial recovery for individuals who have the means to make a lump sum payment but are struggling with the burden of high interest rates and accumulating debt.

However, while debt settlement offers potential benefits, it comes with risks, such as damaging credit scores and potential tax liabilities, since forgiven debt may be considered taxable income. Therefore, it is often viewed as a last resort for individuals facing significant financial hardship.

How Long Does Debt Settlement Stay on Your Credit Report?

Debt settlement doesn’t specifically appear on your credit reports, but certain activities related to debt settlement can stay on your reports for seven years. They include missed debt payments and paying less than the full balance you owe.

During that seven-year period, lenders can review your reports and see that you’ve had trouble paying back debt. During that time (especially for the first couple of years) they might not want to offer you a new loan or credit card. You might have to deal with high APR and costly finance charges, too.

How Debt Settlement Affects Your Credit Score

Settling debt can have both a negative and a positive effect on your credit scores. You’re most likely to see a drop in points up-front, but over time you can regain everything you lost and more. Regardless of the setback, you can always work to experience the benefits of better credit.

Missing Payments

Settling debt isn’t usually the first stage of financial hardship. It’s likely that you settled debt after missing credit card or loan payments or having accounts sold to debt collectors.

If so, your credit scores probably took a big hit already. That’s because your payment history with debt is the biggest factor weighed into your credit scores. In fact, it makes up more than one-third (35%) of your score.

For someone with high credit scores, just one missed debt payment can drop your score by 100 points or more. And those missed payments stay on your credit reports for seven years, although the impact lessens over time.

On the other hand, settling debt can be a strategy for preventing future missed payments. If debt settlement can help you stop missing payments, it might help curtail the damage.

If you find yourself thinking, “I can’t pay my credit cards,” even after debt settlement, take a minute to learn more about debt relief.

Lower Credit Utilization

According to FICO, one way debt settlement helps improve your credit scores is by lowering your credit utilization, also known as your debt-to-credit ratio (DTI).

Credit utilization is the second biggest factor that determines your credit scores (30%). You can improve this area by reducing the amount of debt you owe in comparison to either the amount you originally borrowed (for a loan), or to your credit limit (for credit cards).

To calculate your DTI, divide your debt balance by either your credit card limit or the original loan balance, and then multiply by 100.

DTI = (Total debt balance / credit limit or original loan amount) x 100

Sample Debt-to-Credit Scenario

Charge-offs

After you settle debt, the amount you don’t pay will be charged off by the creditor or collector. Charge-offs will stay on your credit for seven years. They can have a negative impact on your scores, especially right after you settle your debt, and they show future creditors that you did not pay back your debt as originally agreed.

Fees

There are other consequences of debt settlement that won’t necessarily impact your credit, but they can hit your wallet.

If you hire a for-profit debt settlement company, you’ll have to pay them a monthly fee. Unfortunately, they keep collecting the funds — often for as long as 2-3 years — and only send some of it to your creditors after you’ve fallen behind on all the accounts.

In the meantime, your creditors are likely to realize that you don’t plan to pay the full balance. As a result, they may take you to court for the money.

Taxes

When a creditor accepts less than the amount owed, the forgiven debt may be treated as income, meaning the debtor could owe taxes on the amount that was forgiven. If you have more than $600 in debt forgiven, you will have to report the unpaid amount as income to the IRS and pay income taxes on the charged-off amount.

Creditors are required to report forgiven debt over $600 to the IRS by filing a Form 1099-C, “Cancellation of Debt,” which the debtor also receives. The debtor must then include this amount in their taxable income unless they qualify for an exclusion or exception.

For example, if a creditor forgives $10,000 of a $20,000 debt, the $10,000 is generally considered taxable income, and the debtor will need to report it on their tax return.

One common exception is insolvency. If a person is insolvent—meaning their total debts exceed the value of their assets—when the debt was forgiven, they may not have to pay taxes on the forgiven amount, but this requires filing Form 982 and proving insolvency to the IRS.

How to Remove Settled Accounts from Credit Reports

Like any other negative mark, there is no magic answer to removing settled accounts from credit reports.

Sure, many companies promise quick fixes, but their claims are often deeply misleading. The Consumer Financial Protection Bureau (CFPB) warns, “Beware of anyone who claims that they can remove information from your credit report that’s current, accurate, and negative. It’s probably a credit repair scam.”

With that said, there are some ways you might be able to avoid or reduce the credit damage that comes along with debt settlement:

Pay-for-Delete

If you have debt in collections, you may be able to negotiate a “pay-for-delete” solution. This strategy involves offering a lump-sum settlement in return for having the collection account deleted from your credit reports.

If you can get a pay-for-delete agreement in writing, there’s a chance the collector will remove the account from your credit reports. Just keep in mind that they can’t remove the original account from your reports, and they might not honor your agreement at all.

Also, remember that you don’t have to pay any debt that doesn’t belong to you. If there’s a collection debt on your credit reports by mistake, take a minute to learn how to dispute collections and get them removed, without handing over any money.

Paid as Agreed

Another way to reduce the damage of debt settlement is to ask creditors to note the account was “paid as agreed.” In other words, your credit reports will show that you paid the full amount you agreed to pay, rather than just a portion. While this won’t erase the damage of missed payments, it might not be as harmful to your credit as a charge-off.

Re-Aging

Re-aging is a term that can be used in several ways and, as a result, causes a lot of confusion. In the context of debt settlement, re-aging can involve having your creditors bring your account status out of delinquency and into current status. Note that this is not an option for collections.

Re-aging gives you a chance to set up a new plan and pay overdue amounts in the future.  If the creditor agrees, it won’t erase past payment history, but it can prevent future damage.

Here’s the general process to get accounts re-aged:

1. Sign up for a nonprofit debt management plan
2. Have your counselor negotiate with your creditors to bring your past-due accounts current. Note that the creditor might not agree.
3. Resume on-time payments on your accounts.

If you’re looking for other ways to get current on your overdue credit card payments, take a look at a breakdown of debt hardship programs.

Wait

The truth is that there’s no way to remove accurate information from your credit reports ahead of schedule. Whether it’s missed payments or charge-offs, they’ll stay on your credit reports for seven years.

Fortunately, settling debt does not mean your credit will be in the gutter during those seven years. Negative information has less impact on your credit score over time. You can also gain points back by adding positive information to your credit reports while you wait.

Want to see what’s on your reports now? You can pull your credit reports for free from the three credit reporting agencies – Equifax, Experian, and TransUnion – once a year.

How Many Points Will My Credit Score Drop After Debt Settlement?

The impact of debt settlement on a credit score can be significant, but the exact number of points a credit score will drop depends on various factors. In general, debt settlement is viewed negatively by credit scoring models because it indicates that the borrower failed to meet their debt obligations. For most people, a debt settlement can result in a credit score drop of around 100, though the actual decrease can vary based on factors like the person’s credit history, the current score, and the amount of debt settled.

Individuals with higher credit scores before settling their debt typically experience a more substantial drop, while those with lower scores may see a less dramatic change. This is because a higher score indicates a history of good financial management, so any negative mark has a more pronounced effect. Additionally, the more accounts settled or the larger the debt amount, the greater the potential damage to the score.

The impact of a debt settlement will remain on a credit report for seven years, which can make it hard to obtain new credit or loans at favorable terms during that time. However, by demonstrating positive financial behaviors, like paying bills on time and reducing debt, your credit score will improve over time. While debt settlement can provide immediate relief, it’s important to weigh the long-term impact on your credit score and borrowing ability when considering this option.

How Long Does It Take to Improve Your Credit Score After Debt Settlement?

The truth is that there’s no right answer to the question, “How long does it take to improve credit score after debt settlement?”

Yes, your scores are likely to drop after you settle the debt, but you can start working to increase your credit scores right away. If you’re not sure where to start, a nonprofit credit counselor can help you explore options, including a debt management plan.

How to Improve Your Credit After Settling Debt

If you’re looking to improve your credit scores after settling debt, these are some of the best and fastest ways to gain points:

• Ask a friend or family member to add you as an “authorized user” to one or more of their credit card accounts that are in good standing.
• Make a plan for paying off debt faster, which will lower your DTI. The plan could include using a debt consolidation loan or borrowing money from a loved one.
• Review your credit reports and dispute any errors that could be hurting your scores.
• Avoid applying for multiple new loans or credit cards. If you do want to apply, see if you can get pre-approved first.
• Once your scores start improving, request increases to your credit card limits once a year.

Above all else, don’t forget to stay current on your bill payments. Even if you miss just one credit card payment or loan payment, it could set you back. Your other bills could also go to collections if you fall behind.

If you’re looking for professional advice on how to get in good standing and stay in good standing with debt, a credit counselor can help.

Should You Choose Debt Settlement?

Debt settlement can provide significant financial relief by reducing the amount owed and offering a faster path out of debt. However, the trade-offs include a potentially steep drop in credit score, tax consequences, and additional fees. It is often viewed as a last resort for individuals facing serious financial hardship. Anyone considering debt settlement should weigh these pros and cons carefully and explore other options, such as debt management or negotiating directly with creditors, to determine the best course of action.

Pros of Debt Settlement

• Reduced Debt: The most obvious advantage is that debt settlement allows individuals to pay less than the total amount owed, sometimes significantly reducing their overall debt burden. This can provide much-needed relief for those unable to keep up with their debt payments.
• Avoid Bankruptcy: Debt settlement can be an alternative to filing for bankruptcy, which has more severe and long-lasting consequences on credit and financial opportunities. Settlement may be a preferable option for people seeking to resolve debt issues without the stigma or legal implications of bankruptcy.
• Faster Debt Resolution: For those with the means to make a lump sum payment, debt settlement can provide a quicker path to resolving debt compared to long-term repayment plans. This can reduce the stress and emotional toll of lingering debt.
• Debt Relief: The ability to get rid of overwhelming debt, particularly high-interest debt like credit cards, can be a mental and emotional relief. It can offer a fresh financial start, allowing individuals to focus on rebuilding their finances without the constant pressure of unpaid bills.

Cons of Debt Settlement

• Credit Score Damage: One of the major downsides of debt settlement is the negative impact on credit scores. The process can lower a credit score by 100 points or more, depending on the individual’s credit history. This can make it harder to qualify for credit, loans, or favorable interest rates for several years.
• Potential Tax Liabilities: Any forgiven debt amount is often considered taxable income. If a creditor forgives more than $600, the IRS may require the individual to report that forgiven debt as income, resulting in a tax bill that could offset some of the financial gains from the settlement.
• Fees and Costs: Debt settlement companies typically charge fees for their services, which can be a percentage of the settled amount or the total debt. These fees can add up, reducing the overall financial benefit of settling the debt. In some cases, individuals may find themselves in worse financial shape after accounting for these costs.
• No Guaranteed Success: There is no guarantee that creditors will agree to a settlement. Creditors are not obligated to settle, and some may refuse offers or pursue legal action instead, particularly if the debtor has significant assets. This uncertainty adds risk to the debt settlement process.
• Debt Settlement Stays on Credit Report: A settled debt is marked on the credit report as “settled for less than the full balance,” and this negative mark can stay on a credit report for up to seven years. This can hinder the individual’s ability to obtain credit or loans and may result in higher interest rates for future borrowing.

If unsure about the best path forward, consider speaking with one of InCharge’s nonprofit credit counselors. They can provide personalized guidance, help you understand all your options, and work with you to create a plan that fits your financial needs. Don’t navigate the complexities of debt settlement alone—reach out to a trusted expert who can help you make informed decisions and find the best way to achieve financial freedom.