Debt settlement means a creditor is willing to accept less than the balance due for a debt. Settling a debt can hurt credit scores because any payment status other than “Paid as agreed” or Paid in full” looks bad on a credit report. It is likely the creditor will report a settled debt just as “settled” or “paid settled.” Because you aren’t paying your full balance as agreed, debt settlement will have a negative impact to your credit scores.
How credit card debt settlement works
Settling debt with a creditor, mainly credit card companies, involves making an offer to settle the balance owed for a lesser amount. Credit card companies will sometimes accept a lesser amount because it may be more cost efficient then to send an account to a collection agency or to pursue a lawsuit against the customer. The key to debt settlement is customers must have the entire settlement amount up front, in one lump sum.
But there’s a downside to debt settlement and here are few reasons why.
- When an account is settled for less it indicates a higher level of risk because the account is typically overdue.
- Debt settlement indicates you did not honor the original terms of the account agreement as well as walked away from purchases you made and debt you incurred.
- Credit scores may take a dive.
- A tax liability may be created and you end up owing the IRS.
How many points will credit scores drop
With FICO scores, debt settlement will factor in the calculation of your credit score. The reason being is that consumers who settle debt for less than owed have typically missed payments. This means a 30-day, 60-day or worse, a charge-off has been added to credit reports. But late payments are practically essential to debt settlement because creditors are usually only motivated to settle debts that are at risk of never being paid.
FICO doesn’t reveal exactly how many points will drop from your score if you settle but they have listed a range of points your score will drop. The higher your FICO score, the more debt settlement will hurt. If your FICO score is already low, there will be less of a drop. In some instances debt settlement can be just as negative as bankruptcy if your credit score is high. But take this information with a grain of salt. The FICO scoring system is complex and consumer credit profiles respond differently to specific situations.
According to FICO:
- Consumer with a 680 FICO score can experience a drop in score between 45 to 65 points.
- Consumer with a 780 FICO score can experience a drop in score between 140 to 160 points.
- And don’t forget, any delinquencies that led to debt settlement will remain on your credit report for seven years.
How to recover your FICO Scores
Debt settlement will have less of an impact on your credit score the older the information gets and as you add positive information to your credit files and pay other obligations on-time. Once a settled debt is on your credit report for 48 months, it is no longer used in calculating your credit score. But you still need positive information to help counteract the negative information.
Other issues with debt settlement
It may look favorable for a debt settlement notation to appear on your credit report because you made an effort to pay but a lender may still view you as a high credit risk. Lenders may hold it against you that you did not honor the original contract. Settling or paying off the balance of an account does not erase the fact that the default occurred and, therefore, usually does nothing to raise credit scores.
Debt settlement can create a tax liability
When a credit card company forgives any amount of a debt, there’s a real possibility of a tax liability
unless you qualify for an exception or exclusion. The IRS along with your state government can view the amount you did not pay as “forgiven” or “canceled” debt and consider it income. You can end up owing taxes on that “income.”
Credit scores may suffer with or without debt settlement
When weighing pros and cons of debt settlement keep in mind your credit scores can still suffer without debt settlement. If you are struggling to pay your bills on-time, have credit cards that are maxed out or can only make the minimum payments your credit scores can suffer. If you are in this situation you may want to consider debt settlement just to get a fresh start. Your credit scores will recover naturally over time once your debts are resolved plus settling debt puts an end to interest charges, late fees and collection calls.