How Debt Settlement Affects Your Credit Score

If you are overwhelmed with debt you cannot pay, working with a debt settlement company is an option you may be considering. Debt settlement may help stave off bankruptcy, but it isn’t without risk, and even when successful, it can have significant negative consequences for your credit scores.

Debt settlement companies negotiate with creditors on your behalf, with the goal of getting the lenders to accept less than what you owe them. If the company succeeds, you pay a fee consisting of 20% to 40% of the total amount of debt they handle for you.

Types of Debt That Can Be Settled

Debt settlement typically isn’t effective at addressing secured debt—credit that uses property you’ve financed as collateral, such as an auto loan or mortgage. Under terms of those loans, if you don’t keep up with your payments the creditor can (and usually will) seize the property and sell it to get back their money. If they do so and still don’t recoup all you owe them, any remaining outstanding debt could be subject to debt settlement, however. 

Debt settlement is most effective with unsecured debt such as credit card balances and personal loans, and most debt settlement involves credit card debt. Depending on your lenders and the third-party debt settlement agency you’re working with, you may also be able to negotiate settlements on:

  • Medical bills
  • Municipal or federal taxes
  • Student loans
  • Personal loans

Some debt companies claim they can reduce your obligation by 30% to 80%, but their services are not guaranteed. Your creditors don’t have to accept any negotiated offers, and if they refuse, bankruptcy could be unavoidable.

Debt Settlement: Pros & Cons

Any time you’re unable to pay a debt, negotiating with your creditor is an option. You can try doing so yourself, but the process can be daunting, which is why many distressed borrowers choose to work with third-party debt settlement companies.

The premise is the same, no matter the number of creditors you have, the amount being settled, the type of debt you’re dealing with (credit cards or other rotating credit vs. installment debt such as student loans or personal loans):

  • The debt settlement company notifies lenders on your behalf that you cannot pay all you owe.
  • You stop making payments on the debts in question, and the debt settlement company typically has you send them an amount you can manage to pay each month in lieu of paying your creditors. The settlement company uses the money to create a pool of funds they can offer to creditors to settle your accounts.
  • Over a period of 3 to 6 months, your creditors write off your debts, and the debt settlement company negotiates with them in an effort to agree on a partial payment amount. It’s possible one or more creditors will refuse settlement outright, and some could even file suit against you, but many would rather collect some of what you owe than risk getting nothing if you file bankruptcy.
  • If a settlement is accepted, you pay the agreed-upon fractions of your debts in lump sums. (If the debt settlement company hasn’t accumulated sufficient funds to make these payments, you could have to continue sending them money for months or even years until the necessary payments can be made.)
  • Your lender/creditor accepts the partial payment and forgives the remainder of your debt.

Advantages of Debt Settlement

  • Settling your debt is better for you, the lender, and your credit score/credit history than not paying your debt at all.
  • Debt settlement can help you avoid an even worse scenario: declaring bankruptcy.
  • You won’t have to deal with the lender, creditor, collection agency, and other high-pressure debt collectors again.
  • You’ll immediately lower your total debt load, which can present significant benefits for your stress, mental health, and cash flow.

Disadvantages of Debt Settlement

  • Debt settlement is a long, complex process, especially if you’re handling the negotiations yourself.
  • Working with a third-party debt settlement company can add significant fees (some companies charge upwards of 20% to 40% of the debt balance being settled).
  • You’ll have to come up with a substantial lump payment (sometimes as high as 70% of your total balance), which may be difficult if finances are tight.
  • Creditors who accept debt settlement may refuse to lend to you again in the future.
  • All settled debt accounts will remain on your credit reports for seven years, negatively affecting your credit score and acting as a red flag to some potential lenders.
  • The IRS treats most forgiven debt as taxable income, so settling your debts could mean a higher federal tax bill on the heels of paying the debt settlement company.
  • Settling your debt will negatively impact your credit score.

That last point is the one that will be of greatest concern to many people. Your credit scores are a gateway to all future lending, and they are also often used by landlords, utility companies, and others to assess your trustworthiness. The damage done to your credit scores through debt settlement is less severe than that of bankruptcy, but it could hinder your ability to borrow money for years.

Before you settle your debt, get familiar with the specific ways that debt settlement affects your credit score short and long term.

Impact on Credit Score

The debt settlement process typically hurts your credit scores in two phases: During the negotiation process, and after your accounts are settled and closed.

Damage to credit scores begins as you withhold payments to creditors, and missed payments begin appearing on your credit reports. Credit scoring systems such as the FICO Score and VantageScore treat missed payments as significant negative events, so your credit scores will drop. Exactly how much depends on how high your scores were initially, the number of accounts involved, and whether or not you had any missed payments before you began debt settlement. Your first missed payment typically causes the largest score reduction, and individuals with high scores typically see greater reductions in terms of points than those with middling or low scores. As you miss additional payments and delinquencies extend from 30 to 60 to 90 days or more, credit reports will flag those accounts as in default, and credit scores will still suffer further.

If settlement efforts succeed, affected accounts will be closed, ending the accumulation of missed payments, but relevant accounts will be flagged as settled on your credit reports. This may not lead to a large drop in credit scores because your scores will have been so deeply reduced by the missed payments. Settled accounts remain on your credit reports for seven years, exerting a negative effect on your scores the entire time. The extent of this negative impact is usually less than you’d expect with a bankruptcy filing, but it still does affect.

The negative influence any event has on credit scores diminishes over time, so your scores typically will improve as long as you keep up with any remaining accounts or open new ones in an effort to rebuild your credit. It could take a year or two before lenders are willing to accept your credit card applications, but you may be able to start rebuilding your credit by convincing someone with strong credit to act as co-signer or by getting a secured credit card (one with a security deposit equal to its borrowing limit). 

Tips for Choosing a Debt Settlement Company

If you’re clear on the risks and realities of debt settlement and still want to pursue it, take care to choose your debt settlement company carefully. The U.S. Consumer Financial Protection Bureau (CFPB) cautions that many debt settlement companies are unscrupulous and could leave you deeper in debt than when you started. To avoid scammers, consider taking the following steps:

  • Avoid any company that attempts to collect fees up-front before your debts are settled.
  • Beware of any firm that guarantees it can wipe out your debt altogether or that even promises to reduce your debt obligation by a specific percentage; those kinds of assurances just aren’t possible.
  • Make sure the debt settlement company states its fees clearly, so you know beforehand how much you’ll owe them when they finish their work. (Fees should not be contingent on how much they reduce your debt in the future.)
  • Check with your state attorney general’s office and the Better Business Bureau before signing on with a debt settlement service to see if there are any complaints about the company’s practices.

Debt settlement is typically a last-ditch measure aimed at avoiding bankruptcy, so it’s not a process anyone relishes. If you decide to pursue it, go in with your eyes open. Ideally, this stressful process will eventually bring relief from your financial worries.

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