Setting up a debt settlement agreement with a debtor, usually a credit card company, can negatively impact your credit score and your ability to obtain credit in the future. It involves making an offer to the company to accept less than what is owed as a full and final payment of the debt. Although it may relieve the debt obligation and prevent the lender from selling the debt to a collector, it can leave a black mark on your financial history for seven years. (If you would like to setup a debt settlement, check out A Guide To Debt Settlement.)

TUTORIAL: Credit Cards

Working With a Debt Settlement Company
You can make a direct settlement offer to a debtor, but they are most often effected through a debt settlement company working on your behalf. These companies usually take an upfront fee if they are over the internet or in person, but cannot charge an up-front fee if they contact you or you contact them over the phone and are a for-profit company. You pay into a 'dedicated account' instead of to the original lender for a period of time (usually 3 to 6 months). At the end of the agreed-upon time, the company works with the debtor and makes an offer to pay 30% to 50% of the total or the amount collected to date. The credit card company will likely accept this arrangement if you are more than 90 days behind in payments and if they do not believe that you have the resources to settle the debt any other way. To the lender, getting part of the money owed is better than getting nothing.

Settling for Less Than the Balance
By the time your debt gets to the debt settlement stage, your credit rating has already taken a beating. You will have multiple late payments showing; likely three over 30 days, two over 60 days and one over 90 days at a minimum. These late payments drop your credit score up to 200 points. A debt settlement arrangement shows on your credit report as "paid" and not "paid as agreed" which can give your score another black eye. Paying the entire amount owed would harm your score less, although it does not remove the previous late payment reports for seven years. (For tips on how you can improve your debt, read 7 Tips For The Do-It-Yourself Debt Manager.)

Negotiating Credit Bureau Reporting
In some cases, you or a debt settlement company can negotiate with the lender that a condition of the settlement payment is that the arrangement is reported to the credit bureaus as "paid in full." A lender is under no obligation to do this although they might if they simply want the matter wrapped up and closed. It never hurts to ask the lender this if you choose to go the debt settlement route.

Removing an Old Debt Settlement Arrangement from Your Credit Report
Debt settlement arrangements and any related late payments on a debt should fall off of your credit report after seven years. Sometimes, this does not happen, either because the lender has not discharged the debt properly or because the credit report is incorrect. At least six months after a debt settlement has been paid, obtain a copy of your credit report and check how the debt payment was listed. It should show as the account being closed and the debt being paid. If it still shows as open and owing, contact the debtor to have it corrected. If it is still on your report after a full seven years have passed, contact the credit bureaus and inform them to remove it.

The Bottom Line
The debt settlement process is not for everyone and can further damage your credit score. However, it can prevent the debt from being sold to a collection agency, who may only accept payment in full. (To learn what effect paying off your debt will have on your credit score, see Will Paying Off Old Debt Boost Your Credit Score?)

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