How Will Debt Settlement Impact Your Credit Score? It’s Complicated

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. 

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 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. Once your debt is settled, it will no longer appear as a charge-off. Instead, it will appear as settled with less than the full balance.

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 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 credit 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 credit 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.

The difference is that the person with a good credit score is exhibiting a radical change in their payment behavior. If you start with a low credit score, that new negative score tells creditors what they already know: you’re a risky borrower.

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. Think of a drop of red dye. Put the dye in a bucket of water, and you’ll barely notice the tint. Put the same dye in a shot glass, and the whole thing turns red.

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.

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 out 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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READ MORE: Debt settlement companies

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 your credit is fairly good. In that case, what you need is debt consolidation.

READ MORE: Debt settlement vs. debt consolidation

How long does it take to improve credit score after debt settlement

Seven years sounds like a long time. The good news is that credit scoring models 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 credit 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.

Pro tip: Building better credit doesn’t require special knowledge or tricks. Make a budget and live within your means. Pay all bills on time. Use credit cards carefully, use only a small part of your credit limit, and pay every balance in full before the due date. Only use credit when you need it. These steps won’t just help you build better credit. You’ll also save money and improve your finances overall.

READ MORE: Debt settlement qualifications

Can I get a credit card after debt settlement?

Immediately after debt settlement, probably not — unless you apply for a secured card. But once your credit score begins to rebound — within six months to a year — you should be able to get a credit card.

Will my credit score increase after debt settlement?

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

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 cleared the account by paying the due amount. That is what creditors like to see. I
  • 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 called a “charge-off.” 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

Credit scores matter

Your credit score is a three-digit number that has an outsized impact on your life. It’s designed to predict the probability that you will default on a payment obligation. Businesses use it as a gauge of your financial responsibility and reliability.

How are credit scores calculated?

Your credit score is based on information reported to the three major credit bureaus — Experian, Equifax, and TransUnion — by your creditors. This information is then processed by credit score providers like FICO and VantageScore, who use proprietary algorithms to generate scores.

Pro tip: The most critical component of your credit score is payment history. Making all payments on time boosts your score. Late or missed payments hurt it — the later the bills get paid, the more damage they do to your score.

Your score is also heavily affected by your credit utilization rate. This is the percentage of your revolving credit accounts (usually your credit card limits) that you use. If your cards are maxed out, it will harm your credit. Using only a small percentage of your overall credit limit will help your credit utilization.

Your credit mix (the balance between different types of credit), the age of your credit history, and recent credit applications also have a lesser effect on your credit score. 

READ MORE: How to build credit without a credit card

Settling credit card debt: How it works

Debt settlement refers to negotiating with a creditor to close an account for less than the amount you owe. You will either pay the settlement in one lump-sum payment or you will agree on a term payment. After the settlement has been paid in full, the creditor will close the account and consider it paid. If you settle a single debt with no late payments, there will be a single notation on your credit reports that you settled for less than the total amount owed. If you settle more than one debt, each settlement will be listed separately.

Pro tip: Consumers are not obligated to accept any debt settlement offer, and, under Federal Trade Commission rules, can reject it without being charged anything.

READ MORE: Debt settlement qualifications

Debt settlement is used for unsecured debts, like credit cards, medical debt, personal loans, or private student loans. However, not all unsecured debts are eligible for debt settlement. For example, back taxes, child support, alimony or unpaid utility bills cannot be settled.

Secured debts are loans secured by collateral; the creditor has no incentive to settle. They will seize your collateral instead. Secured debts include mortgages and car loans. If your debt is tied up in secured loans, debt settlement will not work for you.

READ MORE: When is debt settlement a good idea?

There are two approaches to debt settlement.

  • Do it yourself: You will need to contact your creditors and negotiate on your behalf.
  • Use a debt settlement program: These for-profit companies will negotiate on your behalf and charge you a percentage of the amount they settle.

According to the American Association for Debt Resolution, debt settlement saves consumers $2.64 for every $1 in fees paid.

Pro tip: The American Association for Debt Resolution was previously known as the American Fair Credit Council.

Whichever approach you use, you will need to stop paying your accounts until they have been charged off (this may increase the debt collection calls for a bit and cause late fees to pile up). You should instead put this money into a savings account so that when the settlement negotiations begin, you have some money stashed away to show that you will be able to make your settlement payments. A legitimate debt settlement company will handle this for you.

READ MORE: Debt settlement fees

Pro tip: Watch out for scams. If a debt settlement company demands that you make an upfront payment, it likely isn’t legitimate. The same goes for a company that promises to fix your credit score. The Federal Trade Commission offers several tips to help ensure that the company you choose is trustworthy. If you believe a company is trying to scam you, please report them to the Consumer Financial Protection Bureau.

READ MORE: DIY debt settlement

Good credit management is important

If you apply for a loan or credit card, your approval will be based on your credit score. If you are approved, your interest rate will be based on your score — the higher your credit score is, the lower your rate will be.

Here are the score ranges for each of the two primary scoring models:

FICO score rangeVantageScore range
Excellent credit800 and up781 and up
Very good credit740 to 799 661 to 780 
Good credit670 to 739601 to 660 
Fair credit580 to 669500 to 600 
Bad credit300 to 579300 to 499

If you’re planning to take on a major loan, like a mortgage or car loan, a small difference in your interest rate can make a difference of thousands of extra dollars over the life of your loan. In fact, sometimes if you take on a new loan or line of credit during the mortgage application process, you must justify why you need that new credit card or loan to the mortgage company.

A good credit score will qualify you for better credit cards, better rewards, improved travel bonuses, longer balance transfer offers and lower interest rates.

Credit scores aren’t just about loans and cards. Good credit can get you out of paying a deposit for utility service. Landlords and even employers check your credit to assess your reliability. If you don’t know your credit score, there are many free ways to obtain it.

READ MORE: Free credit repair

Want to learn more about how debt settlement affects your credit score? Check out this video:

Other debt relief options

Consider these options if debt settlement doesn’t seem like the right option for you.

  • Debt consolidation with a personal loan or balance transfer card won’t reduce the amount you owe, but it will simplify your payments and could reduce your interest rate. This is a good option if your credit is still good enough that you will qualify.
  • A home equity loan or line of credit can be used for debt consolidation. Approval is usually easy, and rates are lower than personal loan rates. Be careful: you could lose your home if you can’t pay.
  • Nonprofit credit counseling agencies can provide valuable advice. Many offer Debt Management Plans, which allow you to consolidate debt even with bad credit. However, you’ll end up repaying your debts in full and will also pay a monthly fee for the DMP.
  • Bankruptcy is an option if you simply have no way to pay your debts. It will hammer your credit, but it will stop all collections and can discharge all of your unsecured debts. You may lose some assets, but most Chapter 7 bankruptcies don’t involve asset sales.

Each of these has pros and cons, so do some research before deciding.

READ MORE: Debt relief programs

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.

FAQs

Will I be able to get a new credit card after debt settlement?

The debt settlement process will damage your credit and may initially make getting approved for a new credit card more difficult. The extent of the damage will vary with the number of debts you settle and your credit score before settlement. You may be able to get a card, but your options may be limited. You may need to start over with a secured card or find a co-applicant or co-signer. Eventually, though, your score will increase and you’ll be able to qualify for a new credit card.

Can I remove settled accounts from my credit report?

Negative entries will drop off your credit report seven years after the account becomes delinquent. This will happen automatically. You don’t need to request it. You will not be able to get accurate entries removed until the seven years elapses.
If an account on your credit report is not yours or contains demonstrable errors, you can dispute the account and have it removed. Otherwise, there is no way to force a credit bureau to remove legitimate, validated information from your credit report.
Beware of anyone offering a magic trick that will delete accurate records from your credit history. That is usually bait for a scam. If you encounter this, contact the Federal Trade Commission.

What are the tax implications of a settled debt?

The IRS classifies forgiven debts as taxable income. Whether you use a debt settlement company or negotiate the settlements yourself, this is true.
A creditor that forgives more than $600 in debt must fill out IRS form 1099-C and supply a copy to you and the IRS. You must include the forgiven amount on your tax return if you receive this form. However, you may be exempt from this if you can show you’re experiencing financial hardship.

What credit score do I need to qualify for a debt consolidation loan?

There is no minimum credit score for a debt consolidation loan. Some lenders work with borrowers with a 520 credit score. However, the interest rates on these loans will be high. Debt consolidation will only save you money if you consolidate at a lower interest rate than what you’re currently paying. You’ll need to decide whether or not a consolidation loan makes sense for your financial situation. Learn more about debt consolidation loans for bad credit borrowers.

Can I buy a house after debt settlement?

Eventually, yes. Probably not immediately after completing a debt settlement plan. Your credit score is made up of several factors:
–Credit score
–Length of credit history
–Monthly gross income
–Loan amount compared to home value (LTV Ratio)
–Debt-to-income ratio (DTI Ratio)
–Housing payment to income ratio (including taxes, insurance, and mortgage insurance if over 80% LTV)
After debt settlement, your credit score will be on the lower side, so it will be best to wait for it to rebound a bit before trying to get a mortgage. The good news is that debt settlement should lower your debt-to-income ratio, which in turn will boost your credit score. The better your credit score, the lower the interest rates you’ll pay for the mortgage, and with a loan that size, what seems like a small amount can be very substantial. So it’s best to wait as long as possible and actively work to build your credit score to qualify for the best possible rates.

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