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.
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.