Does settling a debt hurt your credit? That’s probably the No. 1 question on your mind if you’re considering a debt settlement. If you’re in over your head, settling credit card debt is one way to break free of the cycle of late fees and missed payments. However, you could deal with the repercussions of debt settlement for years to come.
So before you pursue settling credit card debt, learn how it impacts your credit and what you can do instead.
What Is Debt Settlement?
A credit card debt settlement is an agreement between you and your credit card issuer (or a debt collector if your debt was sold off) to reduce your balance in exchange for a lump-sum payment, according to Andrew Latham, a certified personal finance counselor and the managing editor of SuperMoney.com.
For instance, imagine you owe your credit card company $20,000. Because of your financial circumstances, you’re unable to pay off that large amount. You might even struggle to pay your minimum monthly credit card bill, and could be missing payments or making late payments often. With a debt settlement, you would work out a deal with your credit card company to pay less — say, $12,000 — with the provision that the credit card company will forgive the rest of the debt and mark your account as paid.
Though it’s possible to negotiate a debt settlement on your own, most people likely don’t feel confident in their negotiation skills or don’t have the time. Many opt to hire a debt settlement company to negotiate on their behalf. Generally, the debt settlement company will ask you to stop paying your creditor and make monthly payments into an escrow-like account instead. Then, once funds have built up in the account, the company will offer a lump-sum settlement to your creditor. If the company is successful in negotiating a lower balance and you accept the deal, you’ll be charged a fee for its services.
“Typically, debt settlement companies charge around 20% of the enrolled debt balance in fees,” Latham says.
You’re probably thinking: Why would any creditor agree to this? Usually because it’s better than the alternative. If you’ve stopped making payments and it’s unlikely that you’ll be able to pay off your credit card balance, a creditor may want to recoup at least some of that money rather than spend the time and effort chasing down payments indefinitely, or selling the debt off to a collector for pennies on the dollar.
“Even worse for the credit card company, you might file for bankruptcy, making it highly unlikely that the company will recoup any of the money you owe,” Latham says.
However, the option of debt settlement isn’t available to just anyone. There needs to be evidence that you realistically can’t afford to pay your debt. “Typically, they will only do this if you default on your credit card debt, meaning you have missed your payments six months in a row,” says Katie Ross, executive vice president of American Consumer Credit Counseling.
Settling a debt might sound like a Get Out of Jail Free card, but there are consequences if you go this route. Namely, your credit will take a major hit.
How Debt Settlement Affects Your Credit
Debt settlement can ease a huge financial burden, but it can have long-lasting consequences for your credit. Here’s how:
A debt settlement company could make things worse. Though there are some legitimate debt settlement companies, many employ questionable methods that could end up harming your credit score. “Debt settlement companies frequently encourage those who enroll in their services to stop sending payments to creditors during the negotiation period,” says Brian Walsh, senior manager of financial planning at SoFi.
This strategy is meant to give the debt settlement company more leverage during negotiations, as creditors would likely rather settle than receive nothing at all. However, this tactic requires that you stop payments for three to six months while you pay into the settlement company’s escrow account instead and go into default on your credit card debt — all before pursuing an agreement.
Since payment history is the most important credit factor, accounting for 35% of your credit score, it can have a detrimental impact. “This can negatively affect credit scores, which results in digging a deeper hole,” Walsh says.
Your credit score takes a major hit. Once you do settle, your credit report gets another strike against it. A settled account gets reported to the credit bureaus as “paid-settled.” Though this is better than having a charge-off (a balance the creditor has given up trying to collect) recorded on your reports, it’s still not great to have. “This shows future lenders that you are not a trustworthy borrower because you did not pay off the full amount of debt that you owed,” Ross says.
A fresh history of missing payments plus a settlement on your reports is a recipe for bad credit.
As for how much your score will fall, it’s hard to say. “Though there’s no exact amount you can predict your score will drop by, you can expect that the decrease will be quite significant,” Ross says.
The drop depends on your profile as a borrower and what your history with credit looks like. For example, according to analysis by FICO, someone starting with an excellent credit score of 793 can expect the score to fall 113 to 133 points after missing a payment by 90 days. However, a person with a lower score of 607 can expect a much less severe drop of 27 to 47 points. The higher your score, the greater the potential for it to fall after missed payments or other negative marks on your credit history.
It stays on your credit reports for a long time. Seven years, to be exact. If there is no history of late payments, the settlement will remain on your report for seven years from the date it was reported settled. If you do have a history of late payments, the seven-year countdown begins from the date the account first became delinquent.
Fortunately, the severity of having this negative mark on your credit will go down over time, because lenders look at your recent payment history the closest. Still, your credit score will suffer as long as the mark is there. “This can make it difficult to get approved for things like an auto loan, new credit card or even applying to rent a new apartment,” Ross says.
Your credit utilization could go up. Often, when you settle a credit card debt, the issuer will close the account. This could have a negative impact on your credit utilization ratio — the amount of debt you owe compared with the total amount of credit you have available. This number accounts for 30% of your credit score. Creditors want to see that you aren’t too reliant on debt, and prefer a credit utilization of 30% or less. So, if one of your credit cards is closed, the available credit is wiped away. Depending on how much outstanding debt you have on other cards, that could cause your overall utilization to increase.
How Debt Settlement Affects Your Taxes
It’s important to note that having debts forgiven not only affects your credit, but it can affect your income taxes, too. “If you have consumer debt such as credit cards and auto loans that are forgiven, the IRS sees that as income,” says Eric J. Nisall, a tax accountant and founder of Understand Finances.
Creditors that write off your consumer debt may file a form 1099-C with the IRS, and that amount will need to be reported on your tax return. “That means when it comes time to file your taxes, you may owe both federal and state income taxes,” Nisall says.
If you decide to pursue debt settlement, it’s important to speak with a tax professional to find out the potential tax impact and plan for that expense when you file your return.
Alternatives to Settling Credit Card Debt
Because of the impact on your credit and potential tax consequences, you might think twice about pursuing debt settlement. Plus, putting in the effort doesn’t guarantee it’ll work; there is no law requiring credit card companies to negotiate with you, Latham says.
Before you try settling credit card debt, consider these alternatives first:
Debt consolidation. Consolidating all of your high-interest credit cards into one low-interest unsecured personal loan with a fixed monthly payment is a strong alternative to settling, according to Walsh. “However, personal loans do mean that you have to manage monthly debt payments and require you to pay off the loan without missing payments with a firm end date,” he says. “Additionally, personal loans are unsecured, so underwriting might be challenging for those considering debt settlement.” In other words, if you’re in such a bad situation that you’re considering credit card settlement, there might not be any lenders willing to risk lending you money.
[Read: Best Debt Consolidation Loans.]
Debt management plan. These programs are administered by nonprofit credit counseling agencies and help you come up with a budget that allows you to pay off the entire principal amount of debt you owe. Usually, you make payments to the credit counseling agency, which then sends them off to your creditors.
“The credit counseling agency also negotiates with your creditors to get you lower payments,” Ross says. You’ll still have to pay the full principal amount owed, but you’ll likely get a lower interest rate and may have fees waived. “Because you pay off all your debt, a debt management program may actually help your credit score rather than hurt it like debt settlement does,” she adds.
Balance transfer. A balance transfer, where you move debt from one credit card to another, usually taking advantage of a promotional 0% interest offer on the new card, could also be an alternative to settling debt. This is usually a good option for those who have a large balance to pay down but their credit scores are still in good shape.
“While the 0% rate only lasts for a specific amount of time, you have the opportunity to pay off more of the credit card debt during that promotional period as new interest isn’t accruing,” Walsh says. The key is to pay off the balance before the 0% period is up — usually 12 to 18 months from opening — so that debt doesn’t start building up again.
Bankruptcy. If your financial situation is dire, you might consider bankruptcy. “Bankruptcy is a last-resort option for consumers who cannot afford to pay on their debts, whether on their own or through a debt management program,” Ross says. “However, bankruptcy does not necessarily eliminate all debts, and even if you file for bankruptcy, you still must pay debts like child support, alimony, some student loans, divorce settlements and some income taxes.”
Depending on your situation, you can file for either Chapter 7 or Chapter 13 bankruptcy. Chapter 7 allows you to discharge all of your debt at once, while Chapter 13 involves a repayment plan and may or may not include partial debt discharge. Like debt settlement, both options result in a severe negative mark on your credit reports for at least seven years.
“There is no exact number of points you will lose if you file for bankruptcy, as it depends on your previous credit history and your current score as well,” Ross added.
In either instance — bankruptcy or debt settlement — It’s a decision that shouldn’t be made lightly.
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Does Settling Credit Card Debt Affect Your Credit Score? originally appeared on usnews.com