Debt settlement lets an overburdened borrower pay off a loan in a lump sum that can be substantially smaller than what’s owed. It’s a tactic that can clear away a dark cloud hanging over your finances. But beware that a new source of gloom might start to hover, because debt settlement can be bad for your credit score.
The credit reports used to calculate your credit score will show a black mark for any debt settled for less than the full amount. So, while settling a debt can offer big-time relief, it can also create big problems when you need to borrow again, since lenders generally use credit scores to decide whether to extend loans.
But don’t assume that debt settlement is always a bad idea. Much depends on the circumstances. Here’s a look at how debt settlement works and its potential impact on your access to credit, along with tips for choosing a financially healthier alternative.
What Is Debt Settlement?
In debt settlement, you agree to pay off a chunk of a debt, and your creditor agrees to wipe the slate clean of the rest. There are several ways this can come about.
A debt settlement company might offer to negotiate with your lender to get you a good deal. But the Consumer Financial Protection Bureau warns that working with debt settlement businesses can be “risky,” because the federal watchdog says they often charge high fees and encourage consumers to stop paying their bills in hopes of gaining leverage over lenders.
You could wind up with less money and worse credit than before, and little or no debt relief.
Home-brewed debt settlement is another option. Consumers can reach out to creditors on their own and ask if partial payment would settle a debt. This works best for debts that have already been charged off by creditors as uncollectible.
Sometimes, creditors will take the initiative on debt settlement. They may reach out to a customer and offer to take a reduced payoff as a last-ditch attempt to collect on an account that’s long past due.
Whether done with a settlement company’s assistance, through a DIY outreach or in response to a creditor’s offer, debt settlement can produce dramatic savings of 25%, 50% or even more on balances owed. It can be worth considering. But you also must consider the potential hit to your credit score.
How Debt Settlement May Hurt Your Credit
The problem with debt settlement is that when a creditor accepts less than the amount owed, the account isn’t quite marked as paid in full on the borrower’s credit report. The verbiage varies by credit bureau. TransUnion may label the payment status as “payment after charge off,” while Experian will say, “Account legally paid in full for less than the full balance.”
Different credit scoring models also treat debt settlement differently.
But the effect of settling a debt with partial payment is usually negative, often significantly so. That’s because payment history is the biggest single factor in calculating a credit score, representing 35% of the result.
Debt settlement practices can knock down your credit score by 100 points or more, according to the National Foundation for Credit Counseling. And that black mark can linger for up to seven years.
Much depends on circumstance. For instance, a consumer with an already poor credit score due to a history loaded with late pays and collection actions won’t be harmed by settling a debt nearly as much as someone with a nearly pristine 800 FICO score. And sometimes debt settlement can actually help a score, at least in the intermediate term.
How Debt Settlement May Help Your Credit
One benefit to settling an account is that it stops the creditor from reporting updates on it to the major credit bureaus. That starts the clock on the up to seven-year period that “derogatory information” can stay on your credit reports.
Another benefit to settling a debt is that the balance won’t weigh down your credit utilization, which is the amount of your available credit that you’re using. High credit utilization depresses credit scores. Debt settlement eases that pressure.
Legally settling a debt also blocks the creditor from suing to collect it—a clear plus. When a creditor contacts a borrower with a settlement offer, it may be a signal that the lender is moving toward seeking a legal remedy. That alone is reason to seriously consider a creditor’s settlement offer.
When you settle a debt that a creditor has turned over to a collection agency, you can negotiate to have the debt collector report the account as “paid in full” to the credit bureaus and delete derogatory information about the settled debt from your credit files.
The collector may say no to both requests, but it’s worth asking because you could score a double win: You’d avoid paying off the entire amount of a debt and protect your credit score from major long-term damage.
Or, the collector could send you back to the original creditor to make your case for removing the black marks from your credit reports. You’d need to show that you’re making a serious effort to be more responsible with credit.
Debt Settlement Alternatives
If you don’t want to pursue debt settlement, you have other debt relief options that can be less harmful to your credit score.
You could negotiate what’s called a structured debt settlement with a creditor. This type of arrangement may give you more time to repay the debt, and even reduce the interest rate. The outcome can be as positive as debt settlement, but without the credit history hit.
A debt consolidation loan offers a way to restructure debt with no approval needed from creditors. Consolidation replaces your existing debt with an unsecured personal loan or a home equity loan borrowed against your house.
These loans can lower the interest rate on your debt and stretch out your payment term, saving you money and reducing short-term cash pressures. But beware that if you can’t repay a home equity loan, you could lose your house.
A similar move is to get a new credit card with a 0% introductory rate and transfer debts to the card. This can save you plenty of money on interest and won’t hurt your payment history.
Perhaps the smartest move is to take your debt problem to a nonprofit consumer credit counseling agency. These experts can provide assistance with budgeting and also negotiate new terms with creditors while holding the lenders accountable and managing your payments to keep accounts current and help your credit score.
Bankruptcy is the most drastic approach to overwhelming debt. A Chapter 7 bankruptcy can wipe out most unsecured debts fully and permanently, usually in exchange for no payment at all. However, a black mark from a Chapter 7 bankruptcy stays on a credit report for 10 years.
Bottom Line
Debt settlement can help borrowers clear old debts, often for much less than the full amount owed. While it can save cash and reduce your stress level, debt settlement can be costly to your credit score and make it difficult for you to obtain new credit for years.
If you’re burdened with unsustainable debt, settlement is one potential solution that deserves consideration, but others may be less harmful to your credit rating.