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How Debt Settlements Affect Credit History

This article was written by in Debt Reduction. 4 comments.


This is a guest article by Jeremy M. Simon. Each Tuesday, his Credit Score Report column addresses a CreditCards.com reader’s question on credit scoring. He selects questions that either best reflect a common reader concern or that highlight some particularly interesting aspect of credit scoring.

Today, Consumerism Commentary is hosting the weekly question-and-answer session with a query from Amber about her credit history.

Dear Credit Score Report,

If I am offered a settlement by a credit card company or an affiliate (debt collector), how will this affect my credit history? I am not in a good position due to the fact that I am more than 90 days behind. However, I want to repair my credit, not make it worse. Any information would be appreciated that may help in my decision. –- Amber

Hey Amber,

If you enter a debt settlement program — and repay a loan for less than you borrowed — expect your credit score to take a substantial fall.

Debt settlement typically allows struggling consumers to repay their outstanding loans for less than the amount of the original debt. However, that process will cause your FICO score to plunge by up to 125 points, and you may get hit with a big tax bill. The good news, experts say, is that better options might be out there, and a good credit counselor can help you sort them out.

“Settling the debt may or may not be the right action depending on her overall financial situation,” says Rod Griffin, director of public education at credit bureau Experian. “There may be better alternatives.”

That ‘s because debt settlement will impact both your credit score and your wallet. Here’s how it works: Once the card issuer (or affiliated debt collector) accepts your smaller repayment, it will appear on your credit report and impact your ability to borrow for years. “Such a notation will be viewed negatively by lenders,” says Rod Griffin, director of public education at credit bureau Experian. “The record will remain on her report for seven years from the original delinquency date of the debt.” During that time, your lower credit score could mean difficulty borrowing money, higher insurance costs, getting denied for apartment rentals and missing out on job opportunities. Additionally, since the Internal Revenue Service views forgiven debt as income, a settlement could cost you at tax time. That makes debt settlement an expensive option. Still, that isn’t reason enough to rule it out. “Settling debts for less than originally agreed will likely hurt her credit scores at first, but doing so could reduce her debt load and allow her to begin reducing other debts she may have,” Griffin says. “The result, over time, is that her credit scores would begin to improve.” If you do decide to go through with a settlement, experts say you shouldn’t agree to anything over the phone. Get the contract in writing and read it carefully before signing.

If debt settlement isn’t for you, experts say borrowers in your difficult position have four main options:

  • Remain delinquent.
  • Come up with extra money to make payments.
  • Work with a credit counselor.
  • Declare bankruptcy.

Let’s take a look at these options, one by one.

Remain delinquent. At this point, Amber, your credit score has probably taken a major hit due to your delinquency. “If she’s already 90 days behind, she’s already got serious damage,” says Sandy Shore, a senior counselor with New Jersey-based consumer credit counseling agency Novadebt. That’s confirmed by data released last year by FICO, creator of the most widely used credit scoring model that bears its name. FICO acknowledged that a single 30-day late payment can cause your score to drop by up to 110 points. You’re currently three times as late with your card payment — and are only getting later as time passes.

Come up with extra money to make payments. So where can you find the money to repay that debt? Start by making a budget: Take a serious look at your finances, comparing the money you earn each month with the amount you spend. You may be able to earn more money (maybe you can find extra work?), decrease expenses (do you need cable TV?) or sell items (do you really need a TV at all?). Use any extra money to pay down your debt and prevent further damage to your credit score.

Work with a credit counselor. Of course, for many of us, budgeting isn’t an easy process. If you need outside assistance to get a handle on your finances, seek out a credit counselor. You’ll have to pay for their services, but these financial experts can really help. “A good credit counselor will find out what the problem is, how she got into this mess and do a budget,” says Shore.

To locate a reputable counselor in your area, seek out a member of the Association of Independent Consumer Credit Counseling Agencies (AICCCA) or the National Foundation for Credit Counseling (NFCC). Both organizations’ Web sites offer a way to search for local credit counselors via “find” links on their left-hand toolbars. The counselor you select can make arrangements with your creditors, enabling you to make affordable monthly payments toward eliminating your debt, provided your budget allows it. “A good credit counseling agency will not recommend you go on a debt management program unless you can afford it,” Shore says. Entering a debt management program won’t directly impact your credit score, although it can make future borrowing more challenging.

Bankruptcy. You can also weigh the cost of filing for bankruptcy. Declaring bankruptcy means you don’t have to repay the debt, although that filing will cause your credit to drop even more sharply than a debt settlement — by as much as 240 points, according to FICO. To fully consider what’s involved in bankruptcy, have a free or low-cost initial consultation with a bankruptcy attorney (or even several attorneys) to discuss the details of your specific situation. Shore says to remember that just because you visit an attorney doesn’t mean you have to file for bankruptcy. Additionally, if you do decide to file, “there are ways to re-establish credit after bankruptcy,” she says.

In the end, experts say working with a credit counselor is the best choice overall. “They can help analyze your financial situation, offer possible alternatives to regain control of your personal finances and teach you how to avoid making the same mistakes in the future,” Griffin says.

Good luck!

Updated June 20, 2014 and originally published April 2, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Jeremy M. Simon writes about credit scoring, economic data, credit card crime and other issues for CreditCards.com. He is a blogger at Taking Charge. Jeremy is a graduate of Vassar College and has previously worked for Thomson Financial in New York City, where he wrote about the stock markets. View all articles by .

{ 4 comments… read them below or add one }

avatar Dan

I don’t know why advisers advise that taking a debt settlement will hurt your score significantly. I see that advice a lot, and I don’t understand it. A vast majority of the time, debt settlements occur with junk debt buyers/external collection agencies. By the time a debtor is speaking to those people, two things have happened: There is a 90 day late reported on the original creditor’s tradeline, and second, a collection item has appeared on the report. These two things have already torpedoed your score anyway. How, exactly, does the settlement make it worse? (Said a bit differently… once the collection item hits your report, paying it off doesn’t make it go away, nor does the payment improve your FICO score. So why would a settlement decrease your score further?)

Now, if the account is still with the original creditor, then two things are likely true: 1) The account is less than 90 days past due, and 2) There is no collection-related item on the credit report. In that case, yeah, I can see that a settlement program could be harmful. But that’s not really how this was presented in the article — the presentation was “you better think twice about debt settlement” while it should have been, “if you are already in collections, take the gift for what it is, if not, then think twice.”

And finally, the settled difference only results in a true tax basis if you are solvent. If your liabilities (debts) exceed your assets, you won’t pay any tax on this settlement.

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avatar Lance

I agree with most of what this posting states. There are many options for people that have serious debt issues that many do not know about. I have used the NFCC in the past and had good results (my credit card interest rate went from 28% to 6% by joining)

Thank you for the information, look forward to heading more in the future.

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avatar Cynthia

It’s credit that got consumers to this point in the first place! Oh wait you want a loan? You have a good score, so here’s more debt. Go ahead pay 300-400% or more for the cost of the item. But hey you can afford it right, because the monthly payments are “affordable”, until something unexpected happens.

Debt Settlement is the most aggressive way to get out of debt. You basically stop paying creditors and start saving your money for a negotiated pump payoff. Does your score go down? Of course because you basically told the credit card company I’m not going to be a slave to your debt anymore. I want out.

The fact is credit cards are over used. You should use credit for loans for larger purchases. Cars, homes and etc, not consumer spending. People need to learn to save for what they want and buy the item in full.

Credit card companies have everyone fooled and are enslaving people into buy now and pay much more later. It’s really said that consumers have become this naive .

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avatar wylerassociate ♦162 (Cent)

i’ve never had to go through debt settlement to pay off debts but I’m also planning to buy a house in the next 12-18 months so I want my credit history to be as strong as possible.

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