Yes, debt settlement will definitely hurt your credit. If your debt has become unmanageable and you feel like you are drowning in a sea of debt with no life preserver in sight, debt settlement may be a good option to consider. Before you make that decision, however, it is important to know if debt settlement affects your credit.
What is debt settlement and does it hurt your credit?
Debt settlement is a debt resolution strategy that allows you to reduce the amount you owe in exchange for a lump-sum payment. Debt settlement typically consists of four main steps:
- First, you stop paying your creditors on the advice of your debt settlement company.
- Instead, you deposit money into an account set up by your debt settlement company.
- Once there is sufficient money in the account, your debt settlement company uses the money to negotiate with your creditors for a reduced payment.
- When an agreement is reached, the debt settlement company uses the funds in your account to pay your creditors, and your creditors close your debt account.
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 debts do not 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
- There are some other debts that do not qualify, such as federal student loans and credit union debts.
Debt settlement does work for most types of unsecured loans.
These types of loans include:
- 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 credit scores?
Almost every financial decision you make affects your credit score in some way. When you choose debt settlement to get out of financial trouble, there will be a negative impact on your credit score. This is an unavoidable side effect of debt settlement.
There are some things you can do to lessen the hit your credit score will take, however. For instance, if you are settling credit card debt, it is permissible to ask your credit card company about whether it will report your agreement as a settlement to the credit bureaus.
The policies for reporting information to credit bureaus vary from one credit card company to another. If your credit card company reports your account status as a settlement, the effect on your credit score will be worse than if your credit card company agrees to report your account as “paid in full”.
The credit card company is under no obligation to honor your request, but it never hurts to ask for this special consideration. If it is granted, your credit score will not take as much of a nosedive as you might think.
In any event, if you have come to the point of needing debt settlement, your main priority is to get out of debt as quickly as possible and begin re-building your credit. Even if your credit scores have to take a hit for that to happen, it is better to fight your way back to financial independence rather than continue to be enslaved to credit card debt.
What specific credit score factors are affected by debt settlement?
To understand how debt settlement lowers your credit scores, it is good to have a bit of review about how credit scores work. Your credit score is a number ranging from 300-850, which creditors use to evaluate how well you will potentially be able to repay your bills.
The three major credit bureaus (Transunion, Equifax, and Experian) receive information from your creditors about you and then compile that information into a credit risk score. The most common type of credit score is your FICO score.
The algorithm to figure out your FICO score is not known publicly. In general, the way your score breaks down is this:
- Your payment history is the most important part of your credit score puzzle. The timeliness and regularity of your payments count for 35 percent of your total FICO score.
- Your debt-to-credit ratio accounts for 30 percent of your score.
- The length of your credit history makes up 15 percent of your score.
- New credit inquiries account for 10 percent of your score.
- The type of credit you carry accounts for 10 percent of your score.
Debt settlement has a serious effect on the largest two factors of your credit score: your payment history and your debt-to-credit ratio.
Credit to debt ratio
Your credit to debt ratio can be figured by adding the amount of debt that you owe and then dividing it by the amount of credit you have. For instance, in the case of credit card debt, this would be the balance you are carrying on your credit card divided by your total credit limit. This figure is also called your open credit card utilization percentage.
This credit to debt ratio refers only to revolving credit where you have a set limit, but you control the balance by making charges or payments. (source) It is not to be confused with the more recognizable debt-to-income ratio that you may hear lenders talk about when you apply for a loan. Income is not a part of your credit report and does not factor into your credit score.
If you are utilizing debt settlement, your credit to debt ratio is likely already high enough to have had a negative effect on your credit score. It is suggested that if you do not want your credit score to be affected by your open credit card utilization percentage, you should keep that percent down to 30 percent or less.
So, if your credit cards are maxed out, which is often the case when you are considering debt settlement, then your credit score has already taken a hard hit.
The other significant hit your credit score will take relates to your payment history. Credit scores are designed to reward accounts that have been paid according to the original lending agreements between you and your creditors.
When you settle your accounts for less than the original agreed amount, your payment history is affected, and your credit score is lowered.
Also, remember that one of the steps in the debt settlement process is that you stop paying your creditors entirely while your debt settlement company negotiates in your behalf. This means that your creditors will report your payments as late or missed. Once again, your credit scores will take a hit.
How long do settled accounts appear on your credit report?
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 on any new loans or credit cards. The important thing to remember is to avoid getting back into financial trouble by keeping your spending well below your income level.
How can you rebuild your credit after a debt settlement?
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 pay your current bills on time. Maintaining a healthy payment history is a surefire way to improve your credit. For at least a year, be sure to spend at least the minimum balance 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 just 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. To build credit, you have to use it.
But what can you do to improve your credit score if you can’t qualify for any traditional loans or credit cards? Consider the following:
Use a secured loan to build your credit
If you can’t qualify for a traditional loan, consider a secured personal loan (a loan that you obtain by pledging your assets 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.
However, if you go this route, make sure that your lender of choice makes reports to the credit bureaus. No matter how responsibly you make your payments, it won’t improve your credit score if the credit bureaus never find out!
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.
But again, remember to confirm that your credit card issuer reports to the credit bureaus.
Keep your spending well below your credit limit
When your balance on a credit card, loan, or other lines of credit fall below 30% of your credit limit, your credit score jumps up. So if you’re carrying a balance higher than 30%, you should pay it off as soon as you’re able. The sooner you can shrink your balance, the sooner you’ll repair your credit score.
Your credit utilization (how much of your credit limit you’re actively using) determines 30% of your credit score — as such, paying down large balances can make a big difference to your credit!
Use different types of credit
Having a mix of different types of credit helps your credit score. If you’ve only been using credit cards to borrow money, consider taking out a small loan; or if you’ve relied on personal loans, get a credit card!
Note that when you apply for a new loan or credit card, your lender will have to make a hard credit inquiry to evaluate your creditworthiness. In the short term, this “hard pull” will bump your credit score down by a few points. But in the long run, responsible payment behavior spread across a healthy credit mix will help your credit much more than the inquiry will hurt it.
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 you as an authorized user on their account. 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!
Avoid closing credit accounts
If you’ve struggled with debt in the past, you may be tempted to close some or all of your credit accounts to avoid temptation. However, this behavior will hurt your credit score. That’s because it affects two of the factors that determine your credit score: your credit utilization and your credit history. Eliminating credit accounts lowers your total credit limit, hurting your balance-to-limit ratio, and resets your credit history back to zero. If you need to take some space, avoid using your credit accounts for a little while — don’t close them altogether.
Monitor your credit report
When you’re working to rebuild your credit, it’s wise to keep an eye on your credit report and watch out for any potential errors.
Disputing errors on your credit report is relatively simple. Send a letter to the credit bureau and to the company which issued the misinformation to the credit bureaus. Your letter should include your name, the information that you’re disputing, copies of the financial records which prove your claim, and a request that the mistake is removed. You should also enclose a copy of your credit report, with the incorrect items circled or highlighted. Plus, be sure to pay for a “return receipt” so you can be sure that the credit bureau received your correction.
If you’re interested in monitoring your credit score, there are a ton of credit monitoring tools available to you!
Work with a reputable credit repair company
If you suspect that there are mistakes on your credit report, but you don’t know how to find them, a trustworthy credit repair company can help. These professionals are trained to find and remove negative misinformation from your report.
A reputable credit repair company will provide certain information in advance, including:
- A written contract listing the services they’ll provide, along with your legal rights.
- An estimate of the time it will take for them to get results.
- The total cost of their services.
When shopping for a credit repair company, be wary of scammers. These opportunists know that customers seeking credit repair are typically in dire straits, and try to take advantage of their desperation. But as long as you are wary, you can sidestep the scams. When vetting potential credit repair companies, keep an eye out for the following red flags:
- Unrealistic promises or guarantees.
- Requests for payment in advance.
- The company tells you not to contact the credit bureaus directly.
- You’re asked to dispute the information you know to be correct.
- The company suggests that you lie on an application.
- They neglect to tell you your rights.
Speak with a credit counselor
Another great option for if you’re overwhelmed by this process is to work with a credit counselor. A good credit counselor will review your finances and then help you put together a plan of action. With a step-by-step plan in hand, the prospect of achieving good credit should feel far more achievable. Best of all, if your budget is low, you can get credit counseling for free from many non-profit organizations.
However, as with credit repair companies, you should be wary of predatory companies. A good credit counselor shouldn’t make any unrealistic guarantees, and ideally should be licensed by your state.
Is debt settlement worth it?
Considering the negative impact debt settlement can have on your credit score, it is reasonable to think about whether the advantages of debt settlement outweigh the disadvantages.
Here are a couple of things to consider when looking for a debt settlement company.
Do they have minimum and maximum limits on the amount of debt you can enroll?
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 is their customer service like?
We typically don’t care about the customer service of a company until we run into problems or have questions. It is important to find out ahead of time about the level and quality of support provided by a company. You can do so by researching the support channels they offer (phone, email, live chat, etc.) and by reading reviews from past customers. Look for companies like Debtmerica Relief and Rescue One Financial which are recommended by our community of users. Other debt settlement firms to consider are Pacific Debt and National Debt Relief.
While painful in the short term, debt settlement can be the best option to help you avoid bankruptcy and its negative consequences. In addition, after settlements are made, a consumer’s credit report is updated to indicate that the account has been resolved. Getting out of debt in this way sets you back on the path to financial well-being.
To ensure the best possible results, it is important to find a reputable debt settlement company with which to work. Just as you research all your options for debt relief before making a choice, it makes sense to research the debt settlement company that will assist you. Do you need some help right now? Get a free debt settlement consultation with a reputable company today.