How Will Debt Settlement Affect My Credit Score?

Debt settlement typically has a negative impact on your credit score. The exact impact depends on factors like the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled and whether your other debts are in good standing.

A debt settlement's impact on your credit score will also depend on much less than the original balance the debt is settled for and other factors.

Why Debt Settlement Can Ding Your Credit Score

Debt settlement will have a negative impact on your credit score, even though you are reducing your debt obligations.

High 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 may be reluctant to extend you credit in the future.

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 have likely already lowered your score. If debt settlement jump-starts your path toward a sounder financial future, it should be considered.

Let's examine the debt settlement process in more detail.

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, the size of your outstanding balance compared with your 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 Type 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 counterintuitive, 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.

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.

This is also going to sound counterintuitive, but the stronger your credit score before you negotiate a debt settlement, the greater the drop in your credit score. The Fair Isaac Corporation, which sets FICO scores, 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) could lose between 140 and 160 points.

The Bottom Line

A debt settlement arrangement can be an attractive option to eliminate debt that you cannot pay. However, it will most likely negatively impact your credit report, but it can let you resolve financial strain and start fresh.

Consider the pros and cons of debt settlement in your financial situation, and weigh the alternatives. Also take tax consequences into account and perhaps consult with a professional financial advisor about all your options.