Does debt settlement hurt your credit?

What is debt settlement?

If your debts reach an amount that you don’t believe you’ll ever be able to repay, debt settlement is one way to deal with that burden. Outstanding balances that you haven’t been paying for months or even years will continue to grow, putting more and more strain on your finances.

Dealing with multiple creditors, such as credit card companies or medical billing companies, can be overwhelming. By either contacting creditors yourself or engaging a debt settlement company, you ask that creditors accept less than what you owe as final payment. Then, your account with each creditor is closed and considered “settled” – though not “paid in full.”

Debt settlement can result in your paying significantly less than you owe. For example, you might hire a debt settlement firm that negotiates down to 50% of the outstanding balance. This is especially appealing if you’ve missed several payments already.

Daniel Cohen, Founding Partner of Consumer Attorneys, noted that you’re likely to get the best deal through settlement when your account is already charged off or in collections, as your credit has already begun to drop at that point due to the missed payments.

» MORE: Best Debt Settlement Companies

How debt settlement affects your credit

Negotiating a debt settlement can bring you financial relief, but there are some caveats to keep in mind. For one, there are credit impacts that result from a debt settlement. Even if you haven’t missed payments yet, a debt settlement firm will require you to stop making payments to creditors.

Each missed payment on a credit card can damage your credit, and the better your credit is before a settlement, the greater the negative impact on your credit will be. According to Equifax, the reporting date (the date when a creditor reports a delinquent payment to a credit bureau) is usually at least 30 days after the payment due date.

Howard Dvorkin, the chairman of Debt.com, said that in spite of the potential damage to your credit, “if you don’t address your debts, your credit score will plummet even faster and longer.”

If you proceed with debt settlement, the debt will appear on your credit report as settled. It’s possible you could negotiate with the creditor to list it as “paid in full” instead of simply settled, which would improve your optics when future lenders view your credit report.

Short-term vs. long-term credit affects

Debt settlement affects credit in several ways. A short-term impact is that when you stop paying creditors prior to entering into negotiation, your credit score will almost certainly drop.

There’s also a potential long-term impact from closing the accounts that you’re settling. This affects your length of credit history, which accounts for 15% of your total credit score, according to FICO.

Despite these damaging factors, Cohen noted, “It’s better to settle for less than the full balance than to have late payment status.” Settlement isn’t ideal, but in the eyes of creditors, it’s preferable to not paying at all.

Overall, the decision of whether the potential harm to your credit is too great to pursue debt settlement depends on how deep your debt is. If your situation is really dire, a settlement can pull you out of trouble with less harm to your creditworthiness, and you will have time to rebuild your credit after the settlement.

Dvorkin explained, “Taking a temporary hit to get out of debt is always better than slowly sinking into oblivion.” If you’re already in a risky financial situation, seek out the least damaging solution that helps you get back on the right track.

» MORE: Does medical debt affect your credit score?

Alternatives to debt settlement

While handling your debt through settlement can be beneficial, consider other routes, such as debt consolidation or working with a credit counseling agency. These alternatives offer varying levels of debt relief with less damage to your credit score.

A debt consolidation loan can move multiple outstanding debts into one account. These not only may provide relief from having to juggle various creditors and payments, but also can come with a lower interest rate than you’re currently paying. Paying according to the loan terms will be better for your credit than a settlement because you’ll pay your debts in full.

You can also sign up for guidance from a credit counselor. This person can evaluate your finances and debt to offer a feasible solution. Credit counselors may suggest a debt management plan, or DMP, which is similar to a debt settlement.

Dvorkin said that a DMP affects credit score less than a debt settlement, although it may not be powerful enough for someone deeply in debt. He added, “However, if your debts are manageable and your income is stable, a DMP might be a better way to go.”

Bankruptcy is a more drastic solution than settlement, but it does offer, more or less, a fresh start. However, a bankruptcy remains on your credit report for up to 10 years, and it’s a more grueling process with strict qualifications, so it’s better kept as a last resort.

How to improve your credit score after debt settlement

If you’ve settled debt, you’ll want to improve your credit to move forward. Take the energy from getting out from under that burden and direct it toward establishing good new financial habits.

• Change how you handle money from now on. It may be harder to borrow money because lenders will see your changed credit, but you can start small. This starts with keeping current on any new debts.
• Make on-time payments on all accounts. This will go a long way toward rebuilding your credit after debt settlement. While you’ll still deal with the initial fallout from the settlement, over time, your FICO score will improve with regular payments (payment history makes up 35% of your score).
• Follow good money management strategies. Cut spending and stick to a budget, pay bills on time, and save an emergency fund to avoid falling into debt again.

Finally, credit monitoring and checking credit scores are key to staying on top of your finances. Even if you don’t sign up for paid credit monitoring services, you can obtain copies of your credit scores for free. This helps you notice if anyone makes charges to your accounts and watch your progress as your credit score improves.

Bottom line

Debt settlement is a tactic that can help you if you’re struggling with crushing debt. However, paying less than the amount owed will cause a drop in your credit score, so it’s not a perfect solution.

“If you have such crushing debts that you need a settlement to claw your way back into the black, the last thing you should worry about is your credit score,” Dvorkin advised. If it helps you meet your overarching goal of moving beyond your inability to pay debts, a settlement could be worth the temporary and even the long-term impact on your credit.