Debt settlement can be a way out of a bad situation. Settled debt is gone: there are no more collection calls, bills or pressure. But there are still drawbacks. One is the impact on your credit score.
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Our take
- Debt settlement will initially have a negative impact on your credit score but it will rebound as your debts are settled
- After completing the debt settlement program, your credit score should improve quickly (as long as you remain debt-free)
- Credit card issuers will typically close your accounts after they’ve been settled
- Multiple types of unsecured debt can be settled, including credit card debt, personal loans and even some student loans
Four ways debt settlement affects your credit score
Debt settlement can affect your credit score in several ways, not all of which are bad.
1. You’ll have to skip payments in the short term to incentivize your creditor to settle. That means you’ll rack up some late fees and accrue extra interest. But it also hurts your credit score. A single late payment will stay on your credit report for up to seven years. The longer it takes to settle, the longer your credit will suffer before it can begin to heal. However, if your credit score is already damaged, don’t worry so much about how debt settlement could make it worse. It will make your score better in the long run after your debts are settled.
2. Most lenders won’t negotiate settlements until the debts have been charged off. A charge-off appears on your credit account when a creditor gives up on debt collection efforts, closes your account, and writes your debt off as a loss. You still, however, legally owe the debt. Since payment history accounts for 35% of your credit score, charge-offs will be damaging because they establish a pattern of consecutive missed payments. Sometimes a charge-off can lower a score between 50-150 points.
3. When a debt is settled, the lender or credit card company will usually close the settled account. This means that your credit utilization ratio will increase because you’ll have a lower total of available credit. Credit utilization accounts for 30% of your credit score, and it is commonly recommended that you keep your utilization below 30%. If, for example, you settle five credit cards, each with a $15,000 credit limit, when those accounts are closed after settlement, you will lose $75,000 worth of available credit.
4. Debt settlement can actually help your credit score in the long run: If you settle one significant debt and pay it off in a lump sum, it can prevent you from falling behind on your other obligations. One settlement notation will have less overall impact if all your other payments are made in full and on time.
Pro tip: Many sites will tell you that having a “settled” notation on your credit report is what hurts your credit score. That is incorrect. The “settled” notation has a negligible impact on your credit score. It is the account closures and steps leading up to the settlement that will cause damage to your credit score. “Settled” accounts may, however, be a red flag to potential creditors, employers and landlords because your credit report will show that at some point within the past seven years you were unable to repay what you owed in full.
READ MORE: Debt settlement — how to get your debt under control now
How much will your credit score drop?
Predicting the exact impact debt settlement will have on your credit score is impossible. You can still estimate the impact based on several factors.
Your existing credit score
The impact the settlement process will have on your credit score depends mainly on your credit score before debt settlement. People with high credit scores will see a larger impact than those whose scores are already low.
For example, according to FICO, a person with a 793 FICO score who misses a single payment will see their scores drop anywhere between 63 to 83 points. If the payment goes 90 days overdue, the drop will be between 113 to 133 points.
If you start with a 607 FICO score, you’ll see a drop of 17 to 37 points from a payment overdue by 30 days. If the account is 90 days overdue, the hit will be 27 to 47 points.
Your credit history
In general, a person with an extensive credit history will see less impact from a single event, positive or negative, than a person with a thin credit file.
If you have a thin credit file with a relatively good credit score, you can see a very large drop in your score from even a single negative entry. If you have bad credit, your score may not drop much.
How low can your score go?
The higher your credit score, the greater the impact of debt settlement. These are some rough estimates of what you can expect during the negotiation process.
- If your credit score is 730, you could see a drop to 535, almost 200 points
- If your credit score is 630, you could see a drop to 545, less than 100 points
- If your credit score is 505, expect a drop of around 35 points to 470
These drops vary widely depending on the number of accounts affected by the settlement process and your previous credit history.
Weigh the pros and cons of debt settlement by comparing your savings to your credit score impact. We recommend using the calculator below to get started on your savings estimate.
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Pro tip: If you plan to take out a significant loan, like a mortgage or a car loan, debt settlement may not be the best option for you, particularly if you have fair to good credit. In that case, what you need is debt consolidation.
READ MORE: Debt settlement vs. debt consolidation
Settling credit card debt will ultimately help your credit score
Seven years sounds like a long time. The good news is that the FICO scoring models used by the credit bureaus (Experian, Equifax and TransUnion) prioritize newer information. Creditors want to know how you’re handling money now, not how you handled it five years ago.
That means that while negative records will remain on your record for seven years, their impact on your FICO score will fade long before.
If you manage your money well and make your payments on time, you will improve your credit score. This may take anywhere from six months to two years, depending on your prior record and the impact of the settlement process on your score.
READ MORE: Debt settlement qualifications
How long will it take for my credit score to recover?
Eventually, your credit score will increase. It will not be immediate. When your settled debts are repaid, the status will change to settled. That won’t hurt your credit score, but it will also take a couple of months for all of the credit reports to be updated, and you’ll still have those missed payments on your credit history. You will need to re-establish a pattern of on-time payments before your credit score truly starts to rebound.
READ MORE: Debt settlement pros and cons
Can I get a credit card after debt settlement?
Immediately after debt settlement, probably not — unless you apply for a secured credit card. But once your credit score begins to rebound — within six months to a year — you should be able to get new credit.
Paid in full, paid as settled, or charged off: What’s the difference?
A settled debt is a closed account, but it’s not the same as a fully paid debt. Understanding the difference between a settled debt and a fully paid debt is essential.
- Paid in full: A debt recorded as paid in full means you have completely paid off what you owe. That is what creditors like to see.
- Paid as settled: This is a negative entry that will harm your credit score. A settled account is closed, but potential creditors will know you did not pay the total amount. If you did that once, you might do it again, which means more risk for the lender.
- Charge off: If you stop making payments and do not initiate a settlement, your creditor or debt collector will eventually give up. They will write the account off as a loss, which will be “charged off” as bad debt. This is one of the most damaging entries that you can have on your credit report.
Debt settlement will hurt your credit, but it will do less damage than a charge-off or an account in collections.
READ MORE: How to remove a charge off without paying
Other debt relief options
Consider these options if debt settlement doesn’t seem like the right option for you.
- Debt consolidation loans
- A home equity loan or line of credit
- Nonprofit credit counseling agencies
- Bankruptcy
Each of these has pros and cons, so do some research before deciding.
READ MORE: Debt settlement vs. Debt Management Plans
The bottom line
Debt settlement will have a significant impact on your credit score. It can, however, close accounts, get collectors off your back and give you the space you need to get your finances in order.
Remember that the impact of a charge-off or having multiple accounts in collections will be worse. If you can’t pay your debts, debt settlement is probably worth the hit to your credit score. Once you’ve gotten yourself out of debt, you can start rebuilding your credit.
