Not in a good way. Debt settlement typically has a negative impact on your credit score. How negative depends on many factors: the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled, whether your other debts are in good standing, how much less than the original balance the debt is settled for, and a multitude of other variables.

Key Takeaways

  • While debt settlement can be the best option to eliminate outstanding obligations, it can negatively impact your credit score.
  • Ironically, stronger credit scores get dinged by debt settlement harder than poorer ones.
  • The best sort of debt to settle is a single large obligation that is one to three years past due.
  • Do not attempt to settle a debt at the expense of falling behind on your other obligations.

Why Debt Settlement Can Ding Your Credit Score

Why should it have a negative impact, when you're lightening the load of your obligations and your creditors are getting some money? Because strong credit scores are designed to reward those accounts that have been paid on time according to the original credit agreement, before they're closed. A debt settlement plan—in which you agree to pay back a portion of your outstanding debt—modifies or negates the original credit agreement. When the lender closes the account due to a modification to the original contract (as it often does, after the settlement's complete), your score gets dinged. Other lenders are likely to take notice and be more wary about granting credit to you in the future, too.

Still, it is possible that the reduced debt burden is worth a subsequent drop in your credit score. The high credit card account balances and late or missed payments (and if you are considering a debt settlement, probably you are already far behind) have probably already dented it somewhat. If debt settlement jump-starts you on the path to a sounder financial future, it should be considered.

Let's examine the process in more detail.

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Will Paying Off Old Debt Boost Your Credit Score?

How Debt Settlements Work

As you know, your credit report is a snapshot of your financial past and present. It displays the history of each of your accounts and loans, including the original terms of the loan agreement, size of outstanding balance vis-a-vis credit limit, and whether payments were timely or skipped. Each late payment is recorded.

You can negotiate a debt settlement arrangement directly with your lender or seek the help of a debt settlement company. Through either route, you make an agreement to pay back just a portion of the outstanding debt. If the lender agrees, your debt is reported to the credit bureaus as "paid-settled." While this is better for your report than a charge-off—it may even have a slightly positive impact if it erases severe delinquency—it does not bear the same meaning as a rating that indicates that the debt was "paid as agreed."

The best-case scenario is to negotiate with your creditor ahead of time to have the account reported as "paid in full" (even if that's not the case). This does not hurt your credit score as much.

What Sort of Debt Should I Settle?

Since most creditors are unwilling to settle debts that are current and serviced with timely payments, you're better off trying to work out a deal for older, seriously past-due debt, perhaps something that's already been turned over to a collections department. It sounds counter-intuitive, but generally, your credit score drops less as you become more delinquent in your payments.

However, bear in mind that, if you have an outstanding debt that was sent to collectors more than three years ago, paying it off through a debt settlement could reactivate the debt and cause it to show as a current collection. Be sure to get this straight with your creditor before finalizing any agreement.

A debt settlement remains on your credit report for seven years.

As with all debts, larger balances have a proportionately larger impact on your credit score. If you are settling small accounts—particularly if you are current on other, bigger loans—then the impact of a debt settlement may be negligible. Also, settling multiple accounts hurts your score more than settling just one.

Debt Settlement vs. Staying Current

In your credit history, the most weight is given to payment history, with current accounts having the most impact. If you are behind on other debts, it is important to try first to keep a newer, current account in good standing before attempting to rectify the situation of a long-overdue account. For example, if you have an auto loan, a mortgage, and three credit cards, and one of those is over 90 days past due, do not attempt to settle that debt at the expense of falling behind on the other obligations. One unpaid account is better than having late payments on multiple accounts.

30%

The average amount of savings a consumer sees after debt settlement, according to the American Fair Credit Council

This is also going to sound counter-intuitive, but the stronger your credit score before you negotiate a debt settlement, the greater the drop. The Fair Isaac Corporation, the group behind the FICO score (the most common type of credit score) gives a scenario in which a person with a 680 credit score (who already has one late payment on the credit card) would lose between 45 and 65 points after debt settlement for one credit card, while a person with a 780 credit score (with no other late payments) would lose between 140 and 160 points.

The Bottom Line

Facing past due debt can be scary, and you may feel like doing anything you can to get out of it. In this situation, a debt settlement arrangement seems like an attractive option. From the lender’s perspective, arranging for payment of some, but not all, of the outstanding debt can be better than receiving none. For you, a debt settlement packs a punch against your credit report, but it can let you resolve things and rebuild.

Consider the opportunity cost of not settling your debt. If you do not settle, then your score is not hurt right away. However, not settling might lead to continued late payments, going into default, and credit-agency collection attempts. These scenarios may end up hurting your score more in the long run. Sometimes, a clean slate is worth the short-term expense it incurs.

Think about taxes. The IRS usually considers canceled or forgiven debt as taxable income. Check with your tax advisor about any possible tax implications of making a debt settlement.