Editorial Note: We earn a commission on partner links on Forbes Advisor. Commissions do not affect the opinions or ratings of our editors.
Debt settlement allows an overburdened borrower to repay a loan in a lump sum that may be significantly less than what is owed to them. It’s a tactic that can dispel a dark cloud hanging over your finances. But beware that a new source of gloom might begin to loom, as debt settlement can be bad for your credit score.
Credit reports used to calculate your credit score will show a black mark for any debt settled for less than the full amount. So while settling a debt can provide tremendous relief, it can also create big problems when you need to borrow again, as lenders typically use credit scores to decide whether or not to extend loans.
But don’t assume that debt settlement is always a bad idea. It all depends on the circumstances. Here’s an overview of how debt settlement works and its potential impact on your access to credit, along with tips for choosing a financially sounder alternative.
What is Debt Settlement?
In debt settlement, you agree to repay part of the debt and your creditor agrees to wipe the rest of the slate clean. This can happen in several ways.
A debt settlement company might offer to negotiate with your lender to get you a good deal. But the Consumer Financial Protection Bureau warns that working with debt settlement companies can be ‘risky’, as the federal watchdog says they often charge high fees and encourage consumers to stop paying their bills in the first place. hope to have a leverage effect on lenders.
You could end up with less money and worse credit than before, and little or no debt relief.
Home debt settlement is another option. Consumers can contact their creditors themselves and ask if a partial payment would settle a debt. This works best for debts that have already been charged by creditors as uncollectible.
Sometimes creditors will take the initiative in settling the debt. They may reach out to a customer and offer to take a reduced gain as a last attempt at collection on a long overdue account.
Whether done with the help of a settlement company, through a do-it-yourself campaign, or in response to a creditor’s offer, debt settlement can yield huge savings of 25% , 50% or even more on balances due. It may be worth considering. But you also need to consider the potential impact on your credit score.
How Debt Settlement Can Hurt Your Credit
The problem with debt settlement is that when a creditor accepts less than the amount owed, the account isn’t quite marked as paid in full on the borrower’s credit report. Verbiage varies by credit bureau. TransUnion may label the payment status as “paid after being applied”, while Experian will say: “Account legally paid in full for less than full balance”.
Different credit scoring models also handle debt settlement differently.
But the effect of settling a debt with partial payment is usually negative, often significantly. Indeed, payment history is the most important factor in calculating a credit score, accounting for 35% of the result.
Debt settlement practices can reduce your credit score by 100 points or more, according to the National Foundation for Credit Counseling. And this black mark can persist for up to seven years.
It all depends on the circumstances. For example, a consumer with an already poor credit score due to a heavy history of late payments and collection actions will not be harmed by debt settlement as much as someone with a FICO score of 800 almost perfect. And sometimes debt settlement can actually help a score, at least in the medium term.
How Debt Settlement Can Help Your Credit
One of the benefits of settling an account is that it prevents the creditor from reporting updates on it to major credit bureaus. This starts the countdown to up to seven years that “derogatory information” can remain on your credit reports.
Another advantage of settling a debt is that the balance will not burden your credit utilization, which is the amount of your available credit that you use. High credit utilization lowers credit scores. Debt settlement alleviates this pressure.
The legal settlement of a debt also prevents the creditor from taking action for recovery, an undeniable advantage. When a creditor contacts a borrower with an offer of settlement, it may be a signal that the lender is moving towards seeking legal recourse. This alone is a reason to seriously consider a creditor’s settlement offer.
When you settle a debt that a creditor has assigned to a collection agency, you can negotiate to have the collection agent report the account as “paid in full” to the credit bureaus and remove derogatory information about the settled debt from your credit records.
The collector can say no to both requests, but it’s worth asking because you could score a double win: you’d avoid paying off the full amount of a debt and protect your credit score from major long-term damage.
Or, the collector could refer you to the original creditor to justify removing the black marks from your credit reports. You would need to show that you are making a serious effort to be more responsible with credit.
Debt Settlement Alternatives
If you don’t want to pursue debt settlement, you have other debt relief options that may be less detrimental to your credit score.
You could negotiate what is called a structured debt settlement with a creditor. This type of arrangement can give you more time to pay off the debt and even reduce the interest rate. The outcome can be as positive as debt settlement, but without credit history being affected.
A debt consolidation loan offers a way to restructure debt without creditor approval. Consolidation replaces your existing debt with an unsecured personal loan or home equity loan borrowed against your home.
These loans can lower the interest rate on your debt and extend your payment term, saving you money and reducing short-term cash flow pressures. But beware, if you can’t repay a home equity loan, you could lose your home.
A similar approach is to get a new credit card with an introductory rate of 0% and transfer the debts to the card. This can save you a lot of money on interest and won’t hurt your payment history.
Perhaps the smartest decision is to take your debt problem to a nonprofit consumer credit counseling agency. These experts can provide assistance with budgeting and also negotiate new terms with creditors while holding lenders accountable and managing your payments to keep accounts current and improve your credit score.
Bankruptcy is the most drastic approach to overwhelming debt. A Chapter 7 bankruptcy can erase most unsecured debt completely and permanently, usually in exchange for no payment. However, a black mark from a Chapter 7 bankruptcy remains on a credit report for 10 years.
Find out if you qualify for debt relief
Free and non-binding estimate
Debt settlement can help borrowers settle old debts, often for much less than the total amount owed. While it can save money and reduce your stress levels, debt settlement can be costly to your credit score and prevent you from getting new credit for years.
If you’re burdened with unsustainable debt, settlement is one potential solution worth considering, but others may be less detrimental to your credit rating.