Credit Sesame discusses whether debt settlement affects credit score.
If you have overwhelming debts , you might be considering debt settlement — asking creditors to accept less than what you owe as payment in full. This is a way to erase your debt balances quickly, but how does debt settlement affect your credit score?
How debt settlement works
Debt settlement, aka debt relief, means negotiating a lower payoff for unsecured accounts like credit card balances. You offer your creditors a lump sum in exchange for immediate forgiveness of the remaining balance. Here are important facts about the process:
Creditor perspective
- Most creditors do not negotiate until your account is several months past due. If they believe that they can collect what you owe, they have no reason to accept less.
- Creditors do not have to negotiate with you. They can send your account to collections or even sue you for the balance. Expect a lot of phone calls and collection activity.
- Creditors are most likely to settle when they believe you cannot afford to pay your entire balance.
- Creditors that settle forgive about half of the balance on average. Debt buyers who pay pennies on the dollar for your debt may be willing to take a much lower amount.
Consumer perspective
- Most consumers do not have ready cash to settle; instead, they stop paying their unsecured creditors until they can save enough to make a settlement offer.
- Many consumers hire debt settlement companies to negotiate for them.
- The older your debt, the more likely creditors are to settle.
The impact of debt settlement depends on your credit score prior to settling, how long it takes to settle and how the creditor reports the arrangement to credit bureaus. In general, however, the immediate impact of debt settlement on credit scores is severe.
Does debt settlement affect your credit score?
Absolutely. FICO data show that consumers starting with a 680 credit score see a 45-65 point drop when they settle one credit card. The higher your starting score, the more dramatic the fall — those starting at 780 experience a 140-160 point decrease. Typically, the creditor reports the account as “settled for less than the balance owed.”
There’s more. Those statistics reflect only the settlement, not any missed payments that happen before settlement. You need to remain current on the accounts, have ready cash to offer and persuade your creditor to settle an account that’s current. This almost never happens. The reality is that most consumers miss months of payments while they save a lump sum to offer.
In fact, according to a July 2022 Freedom Debt Relief study entitled Debt Settlement and Bankruptcy: a Comparison of Credit Scores, the credit score of debt settlement clients drops a median 161 points to 485. Scores hit bottom about six months after beginning a program.
It’s important to note that the subjects were clients of a professional debt relief company. They typically miss months of payments to save a settlement sum. If you can come up with the money by selling assets, borrowing or withdrawing savings, you might spare yourself some of that drop.
Does debt settlement affect credit score after settlement?
After debt settlement brings balances under control, late payments on those accounts cease. So do penalties for having high credit utilization. According to researchers, “typical debt settlement clients experience a sharp recovery in their credit scores that eventually transitions into a steady recovery.”
Two years after settling, consumers have much healthier credit scores. Compared to Chapter 7 and Chapter 13 filers, clients who settle debts experience a stronger credit score recovery.
How to recover after settling debt
There are ways to lessen the damage from debt settlement and recover sooner. Whether you work with a professional debt relief firm or settle debt yourself, these strategies can help re-establish good credit.
- Continue making on-time payments on other debts. You may have difficulty opening up new accounts after settling, so make sure the ones you have add good payment history to your credit report.
- Minimize the damage by coming up with lump sums to offer as quickly as possible. Sell everything you do not need. Consider borrowing against your 401(k) if your employer allows it.
- Contact your creditors as soon as possible. Document why you cannot afford their payments and show that you are making a good-faith effort to pay what you can.
- Creditors are more likely to settle if you show that your financial problems are not your fault — a job loss, medical catastrophe, divorce or another event that you cannot control.
- Add positive trade lines by applying for “second chance” or secured credit cards. Make sure the issuers report your payment history to all three credit bureaus and choose ones with reasonable fees.
- Ask friends or family members with good credit to add you as an authorized user to one of their credit cards. You do not need to use their account (in fact, you do not even need to know what the account number is or have access to a card). But their good repayment history shows up on your credit report and improves your credit score.
Be better than average
According to the Freedom Debt Relief study, the median score of debt settlement clients six years after settling was 676. While that’s better than scores of bankruptcy filers, it’s below average for all consumers with credit scores. You can continue improving with these good habits:
- Use any credit cards you have conservatively. Always pay on time and avoid carrying balances.
- If your debt problems stem from overspending, consult a non-profit credit counseling service. They can teach you to budget and manage your debts.
- Establish an emergency savings account to avoid debt problems in the future. Even a few hundred dollars saved can head off many common problems like car repairs.
- Look for ways to cut spending or increase your income. Find a better-paying job or a side gig. Take in a roommate. Drop a streaming service or subscription. The more wiggle room you have between your income and your expenses, the easier it is to pay your bills on time.
- Avoid missing payments by setting up autopay for bills or creating reminders on your calendar. And remember, a payment is only late for credit reporting purposes 30 days after the due date.
Monitor your credit to flag reporting errors, catch identity theft, and to see how different financial behavior affects your credit scores. Credit Sesame’s free credit monitoring can help you stay on top of your credit profile with daily alerts and free monthly credit scores.
You may also be interested in:
- How Debt Consolidation Affects Your Credit Score
- How Does a Debt Management Plan Affect Your Credit Score?
Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.
