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How Will Debt Settlement Affect My Credit Score?

By Edited Nov 23, 2016 0 0

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How will debt settlement affect my credit report? This is a concern on the minds of many consumers with unpaid debt. A settlement occurs when a creditor accepts less than what you owe on an account as payment in full. Once the creditor receives the agreed amount, the company reports the debt to the credit bureaus as “Settled” or “Paid in Full,” depending on the agreement. The credit-reporting agency updates the data on your credit report, and all collection calls regarding that particular account should cease. Although this may sound like the ideal situation, it is not as simple or problem-free as it sounds. While a debt settlement might provide some relief, you do well to consider the negative effects that a debt settlement could have on your credit score.

Debt Settlement Through Self-Negotiations

If you are about 6 months behind on your payments, your creditor might make a settlement offer in an attempt to collect at least a portion of the debt. This means that your credit report already contains some negative information due to falling behind on your payments. You can minimize the negative effect on your credit report if you reach a settlement before the account goes to a third-party collection service. 

If you made your payments on time prior to running into problems, your creditor might agree to report the debt as “Paid as Agreed” or “Paid in Full” to the credit agencies. This scenario is your best choice, as it would damage your credit the least. 

If your creditor is not agreeable to your request, the account will likely appear on your credit report as “Settled.” The forgiven amount generally appears on the credit report as well.  As a result, it could possibly affect your ability to obtain credit in the future. However, a “Settled” debt is better than an “Unpaid“ debt.    

Debt Settlement Through a Debt Settlement Company

Debt settlement companies are third-party services. Such services often lure customers with the promise to slash bills in half or eliminate interest fess and late charges. However, not all companies are reputable and few live up to their promises. The consequences of settlements through a third party will largely depend on your payment history. 

If you have a good payment history with a creditor, settling through a third party would likely damage your credit. First, creditors do not have a reason to settle if you are current on your payments. This means that a debt settlement service will attempt to negotiate with your creditor only after your account is about six months delinquent.  

The third-party service will likely place any payments you make to the company in an account until you have enough funds to make a settlement offer. During this time, your creditor or creditors do not receive any payments. Therefore, if you had good credit at the time of signing up with the settlement company, your credit report will now contain damaging information. 

On the other hand, if you are dealing with old debt, settling through a debt settlement company might not have much of a significant negative impact on your credit. The reason is that your credit report already contains negative information. 

It is important to understand that not all creditors are willing to negotiate with settlement companies or credit counseling services.  Your creditors can sue you while you are making payments to a third-party service. 

Debt Settlement Through a Collection Agency

It is better to settle an account before it goes to collection. However, if a collection agency is already handling your debt, settling the debt is better than ignoring it. Additionally, although your debt is already delinquent, paying the debt in full might have a more favorable effect on future creditors than a settled debt. 

5 Aftereffects of Debt Settlements

  • While settlements do have a negative effect on your credit score, by the time you settle a debt, your credit would have already suffered some damage.
  • Creditworthiness, your ability to meet financial obligations, consists of your debt-to-income ratio and your credit score. You can expect your credit score to drop significantly after a settlement. In contrast, your debt-to-income ratio will increase, as you will have less debt.
  • It takes about two years for your credit score to improve significantly, providing that you do not incur too much debt in the meantime and pay your bills on time. Fortunately, creditors often look back only two years when determining your ability to care for your financial obligations.  
  •  It takes about 7 years for debt settlements to fall off your credit report.
  • If any of your creditors forgive $600 or more in debt, you will likely need to include it in your tax return and pay taxes to the IRS. Seek the advice of your accountant, as there are some exceptions. 

Overall, the degree to which a settlement affects your credit score generally depends on your payment history up to the point that you settle a debt. For instnace, if you are current on your payments and you start missing payments simply to qualify for a reduced settlement, your credit score will suffer greatly. However, if you are dealing with unpaid debt, a debt settlement might be your best option.

Copyright © 2011 Ana Jackson. All Rights Reserved. Reproduction in whole or in part constitutes plagiarism, is illegal and strictly prohibited.

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