What Happens To Your Credit Score When You Settle Debt
Settling debts can be a huge financial victory. While paying off your debt in its entirety can be the ultimate financial goal, sometimes debt settlement can be a welcome way to finally handle debts that you've been struggling with. Unlike traditional debt pay off, debt settlement (aka debt relief or debt adjustment) usually allows you to settle a debt for a lesser amount than what you owe, provided you pay the settled amount in full. While this strategy can help you get debts off your plate, there are some significant financial downsides to be aware of.
For starters, you might find yourself wondering when, exactly, that debt will no longer appear on your credit report. Even worse, you might be wondering why you experienced a drop in your overall credit score. Instead of being met with positives, it can feel like you're being punished for settling debt finally. This can feel frustrating, even counterintuitive, to the goal of building credit, so let's break it down.
The ugly truth is that debt settlement will still appear on your credit report (and therefore influence your credit score) for seven years. Plus, the initial hit to your credit score after settling your debt can be by as much as 100 points, according to the Federal Trade Commission. What's more, you may be surprised to learn that those who hold stronger credit scores are actually more likely to experience significant credit score drops as a result of debt settlement.
How debt settlement works
Debt settlement is generally handled by third-party for-profit companies that negotiate to settle your debts across multiple lenders into a single, lower amount. This strategy is typically best used on old, past-due debt since most creditors won't negotiate debts that are current and paid in a timely manner. While using a settlement strategy can obviously help you finally pay off your debt, how it's reported to credit agencies is what is ultimately hurting your credit score.
Since your lender has to report that the account is closed, it'll typically report the account's closure was the result of a modification to the original loan contract. By saying the account was settled, your lender is essentially branding you with the fact you were not able to pay off your debt in full. This, like bankruptcy, can signal to other lenders that your ability to handle credit isn't reliable and it goes without saying that this can negatively impact your ability to extend or obtain new credit for some time.
It's also important to realize that there are different factors that can impact just how severely your credit score might drop after settling a debt. The status of your current credit, the reporting practices of your creditors, the exact size of the settled debt, and if you have other still-unsettled debts (and if they're in good standing or not) can all play a part in the credit score hit that happens after a debt settlement.
Alternatives to settling a debt
If you're not sure if debt settlement is right for you, it's important to know there are alternatives to settlement and even some ways you can negotiate how a debt settlement is reported on your credit report. While paying off debt in full and on time is the goal, life has a tendency to get in the way of those plans. Due to the downsides of debt settlement, it should be used as a last resort after you've already pursued other avenues.
Debt consolidation, strict budgeting, and reaching out to your lenders directly can all be valuable steps to take before settling your debt. Further, calling your creditors before collections agencies get involved can prove key in negotiating a more manageable payment schedule. Depending on just how old or delinquent the debt is, you can investigate its statute of limitations to determine if it's time- barred (i.e., unable to be sued for collections).
With that in mind, sometimes you've tried everything and are left with few choices outside of debt settlement. If you decide to move forward with a settlement strategy, see if you can negotiate with your lenders about how they classify your closed account(s). Your credit score won't be hit nearly as hard if you're able to negotiate your account as "paid in full" upon closing, rather than having it be listed as "settled" on your credit report. Even if the past-due account isn't, technically, paid in full, some lenders might be willing to negotiate this as part of the settlement agreement.