In general, debt settlement typically has a negative impact on your credit score. The exact impact depends on a multitude of factors: the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled, whether or not your settled debts are presently in good standing, how much less than the original balance the debt is settled for, and a multitude of other variables.

Why should that be, when you're lightening your total debt load and your creditors are getting some money? It's because strong credit scores are designed to reward those accounts that have been paid on time per the original credit agreement before being closed. A debt settlement plan – in which you agree to pay back a portion of your outstanding debt – by nature 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, it is generally because you are already far behind) have probably already dented it somewhat. Your credit report reveals a history of each account, including whether payments were made on time, original terms on the loan agreement and other information about how you maintained the account; each late payment is recorded).

Details of Debt Settlements

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

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 only 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 have a slight positive impact if it erases a 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.

Other points to consider

  • Settling multiple accounts hurts more than settling just one.
  • 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.
  • If you have an outstanding debt that was sent to collectors 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.
  • In your credit history, the most weighting is given to payment history, with current accounts impacting the most. 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, one of which is over 90 days past due, do not attempt to settle that debt at the expense of falling behind on your other obligations. One unpaid account is better than having late payments on multiple accounts.
  • A debt settlement remains on your credit report for seven years. If your settlement took place over seven years ago and is still showing on your report, contact the lender and the credit bureau to have the record changed and the settlement removed.

The Bottom Line

Facing past due debt can be a scary situation, and you may feel like doing anything necessary 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 mighty 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, default and credit collection attempts. These may end up hurting your score more in the long run. Sometimes, a clean slate is worth the cost.

For related reading, see "A Guide to Debt Settlement" and "Negotiating a Debt Settlement."

  1. How do balance transfers affect my credit score?

    Learn the ways a balance transfer can negatively and positively affect your credit so you can pay off debt while maintaining ... Read Answer >>
Related Articles
  1. Personal Finance

    Debt Settlement: A Guide for Negotiation

    Negotiating a settlement should encourage everyone to try, find out how you can negotiate your way to a lower debt load by paying up front.
  2. Personal Finance

    Debt Settlement: Cheapest Way to Get Out of Debt?

    Debt settlement is not for everyone, but for those seriously in debt it may prove an effective means of solving the problem.
  3. Personal Finance

    4 Habits That Damage Your Credit Score

    Many common money habits can affect your credit score negatively without you even knowing it.
  4. Personal Finance

    7 Tips For The Do-It-Yourself Debt Manager

    Hired gun not in your budget? Learn to be your own credit counselor.
  5. Personal Finance

    Surprising Ways a Mortgage Affects a Credit Score

    It takes a good credit score to get favorable mortgage rates. Then, how you pay a mortgage will shape your score – just having one can lower it at first.
  6. Personal Finance

    What's Keeping You From an Excellent Credit Score

    Learn what affects your credit score most and what might be lowering your score without you knowing it.
  7. Personal Finance

    Is Your Credit Score at 850? It Can Be!

    Use these tips to increase your credit score and your ability to get low interest rates on loans.
  8. Personal Finance

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
  9. Personal Finance

    New Credit Scoring Forgives Small Debt

    FICO 08 means that certain types of old debt won't affect your credit score, but it's not all good news.
  10. Personal Finance

    Why You Should Improve Your Credit and How to Do It

    With credit playing a big role in many financial decisions, it is important to maintain good credit.
  1. Consumer Credit File

    A consumer credit file contains data about a consumer’s past ...
  2. Rolling Settlement

    A rolling settlement is the process of settling security trades ...
  3. Credit Card Debt

    Credit card debt is a type of unsecured liability which is incurred ...
  4. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
  5. Authorized Settlement Agent

    An authorized settlement agent is a bank that is authorized to ...
  6. Account Settlement

    An account settlement generally refers to the payment of an outstanding ...
Trading Center