Does Debt Settlement Hurt Your Credit? 7 Things to Know
JM
Last updated 03/19/2024 by
Jill McConaghieIf your debt has become unmanageable and you feel like you are drowning in a sea of debt collectors with no life preserver in sight, you may be considering debt settlement as an alternative to other options such as a debt consolidation loan or bankruptcy.
However, before you make that decision, it is important to know how debt settlement will affect your long-term financial health.
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What is debt settlement?
Debt settlement is a debt resolution strategy that allows you to reduce the amount of your debt in exchange for a lump-sum payment. Debt settlement companies generally work like this:
- First, on the advice of a debt settlement company, you stop paying your creditors.
- Instead, you deposit money into an account set up by that company toward your eventual settlement payment.
- Once there is sufficient money in the account, the company will negotiate with your creditors for a reduced payment.
- When an agreement is reached, the debt settlement company uses the funds you’ve already paid them to pay your creditors, and your creditors close your accounts.
Does debt settlement work?
In some cases, a debt settlement company can negotiate with your creditors to reduce the amount you owe by anywhere from 30 to 50 percent.
However, debt settlement should rarely be your first choice for resolving financial problems. If you are not already behind on your payments and are not experiencing clear financial hardship, your creditors will be unwilling to settle for less than the full amount you owe.
For debt settlement to work, two basic things have to happen. First, your creditors must be willing to negotiate with you to settle your debt for a deep discount. Second, you must be able to demonstrate that you can actually uphold your end of the settlement agreement and pay the newly agreed-upon balance.
What are the requirements for debt settlements to work?
Generally, debt settlement companies negotiate with creditors to reduce the amount of your debt owed between 30-50%. However, debt settlement should rarely be your first choice for resolving financial problems. For debt settlement to work, two essential things have to happen.
First, your creditors must be willing to negotiate with you on a settlement offer for a deep discount on your debt. If you are not already behind on your payments and are not experiencing clear financial hardship, your creditors will be unwilling to offer a lump sum settlement for less than the full amount you owe.
Second, you must be able to demonstrate that you can actually uphold your end of the settlement agreement and pay the newly agreed-upon balance.
Most companies require you to have a minimum amount of debt, which is usually around $10,000. Some lenders, such as Freedom Debt Relief, accept lower amounts. Other companies also have a maximum amount of debt you can enroll, such as $100,000. You will need to find a company with requirements that match your needs.
What types of debts don’t qualify for debt settlement?
Not all of your debts can be handled with debt settlement. For instance, debt secured by collateral does not qualify for debt settlement. Some common types of secured debt are:
- Home mortgages
- Car loans
- Boat loans
Some types of unsecured debt will not qualify for debt settlement, including federal student loans and credit union debts. But debt settlement does work for most types of unsecured debt, such as:
- Credit card loans
- Unsecured personal loans
- Medical bills
- Utility bills
- Apartment leases
- Department store cards
- Old judgments
- Private student loans in default
- Personal lines of credit
How does debt settlement affect your credit report?
Unfortunately, using debt settlement will likely hurt your credit score in the short term. To understand why, let’s look at a brief explanation of how the scoring model for your credit report works.
Your credit score ranges from 300 to 850. Lenders use it to evaluate your creditworthiness and predict how likely you are to repay a loan. The three major credit bureaus (Transunion, Equifax, and Experian) calculate this number from the information in your credit file that they receive from your creditors.
The most common type of credit score is your FICO score. The algorithm used to determine your FICO score is not known publicly, but there are several generally known factors that can impact it:
- Your payment history counts for 35% of your total FICO score.
- Your debt-to-credit ratio accounts for 30% of your score.
- The length of your credit history makes up 15% of your score.
- New credit inquiries account for 10% of your score.
- The type of credit you carry accounts for 10% of your score.
Notice that your income is not used to calculate credit scores since this is information you report separately to a potential creditor.
Debt settlement impacts credit scores based on two factors: your debt-to-credit ratio and your payment history.
Debt-to-credit ratio
This figure is also called your open credit card utilization percentage. It’s the amount of debt you have compared to your available limits. This refers only to revolving credit, where you have a set limit, but you control the balance by making charges or payments. (source)
To avoid a negative impact on your credit score, you should keep this ratio down to 30% or less. If you’re considering debt settlement, especially because your credit cards are maxed out, your debt-to-credit ratio is likely already high enough to hurt your score.
Payment history
The other significant hit to your credit report from using debt settlement is on your payment history. Making late payments reflects poorly on your credit history. So, how does debt settlement affect this part of your score?
First, remember that one of the steps in the debt settlement process is to stop paying your creditors entirely while your debt settlement company negotiates on your behalf. This means that your creditors will report your payments as late or missed.
Also, credit scores are designed to reward accounts that have been paid according to the original lending agreements between you and your creditors. Settling an account with a creditor for less than the original agreed-upon amount reflects negatively on your credit report.
Lessening the impact on your credit score
A negative impact on your credit score is an unavoidable side effect of debt settlement. However, there are some things you can do to lessen the damage.
If a credit card company you are negotiating with reports your account status to the credit bureaus as a debt settlement, it will not help your credit score. But the policies for reporting that information vary from one creditor to another. Instead, you can ask that they report your account as paid in full.
The credit card company is under no obligation to honor your request, but while you’re negotiating to settle a debt, it never hurts to ask for this special consideration. And if it is granted, the impact on your credit score is greatly reduced.
How long do settled accounts appear on your credit history?
A settled account stays on your credit report for seven years. Even though the account is closed, it continues to affect your credit score during the seven-year period. However, once your debt is settled, you can begin rebuilding your credit through responsible borrowing and making timely payments to your new lenders.
How can you rebuild your credit after a debt settlement?
Although settling debts through a debt relief company can hurt your credit score in the short term, it’s better to fight your way back to financial independence than to continue to suffer from credit card debt.
If you absolutely need a debt settlement, your next goal should be to get out of debt as quickly as possible and begin rebuilding your credit. So, what tangible steps can you take to repair your credit? Consider the following.
Pay your bills on time
The best thing you can do is to avoid late payments. For at least a year, be sure to pay the minimum payment or more on all of your bills before they are due. Your ability to pay your bills on time determines 35%of your credit score, so establishing a consistent rhythm of responsible behavior will help.
Use credit responsibly
If you recently got out of credit debt, it might be tempting to avoid using credit altogether. However, if you have no credit activity, your credit score will not change — it’ll be determined only by your past behavior. The more you use credit responsibly, the faster your credit score will go up.
Use a secured loan to build your credit
If you can’t qualify for a traditional loan, consider a secured personal loan (a loan you obtain by pledging your assets to lenders as collateral). Because these are secured loans by collateral, even borrowers with abysmal credit can qualify. And if you make your payments consistently, it will help your credit score.
Get a secured credit card
Another way to improve your payment history is to get a secured credit card. You don’t need good credit to qualify for a secured credit card, and if you make your monthly payments consistently, it can help your credit.
Just be aware that some secured credit card providers don’t report to the credit bureaus, so check beforehand that the creditor does before signing up.
Keep a low balance on your credit cards
When your balance on a credit card, loan, or other lines of credit falls below 30% of your credit limit, your credit score jumps up. If your balance is more than 30% of your credit limit, you should try to pay more on the balance every month to lower it below 30% at the very least.
Become an authorized user on someone else’s credit card
If you have a trusted friend or family member whose credit is in good standing, ask them to add your name as an authorized user on one of their credit card accounts. This way, their responsible payment behavior and low credit utilization will be reflected on your credit report. Just be sure not to take advantage of their kindness by drawing funds from their accounts!
Work with a reputable credit repair company
If you suspect that there are mistakes on your credit report but are not sure how to address them, a trustworthy credit repair agency can help. These professionals are trained to find and remove negative misinformation from your report, which can immediately get you a lower interest rate.
Speak with a credit counselor
Another great option is to work with a credit counselor. A good credit counselor will review your finances and give you expert advice to help you put together a plan of action.
With a step-by-step plan in hand, the prospect of attaining good credit should feel far more realistic. Best of all, if your budget is low, you can get credit counseling for free from many non-profit organizations.
Is debt settlement worth it?
Considering the negative impact debt settlement can have on your credit score, it is reasonable to consider whether the advantages of debt settlement outweigh the disadvantages.
While painful in the short term, using this strategy to settle a debt can be the best option to help you avoid bankruptcy and its negative consequences. After settlements are made, a consumer’s credit report is updated to indicate that the debt has been resolved.
The bottom line is that getting out of debt in this way can give you a fresh start and save you some money. However, it can also hurt your credit score and set you back on your road to financial well-being.
To ensure the best possible results, choose a reputable debt settlement company to help you. Be sure to research all your debt relief options before making a choice and find the best fit for your circumstances.
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