If you’re in debt and already behind on payments, debt settlement is a viable option to save you money and help you get a fresh start. But as with debt consolidation, debt management plans, and bankruptcy, it’s natural to wonder how settling your debt may affect your credit score. As you consider all of your options, here’s what you need to know about the debt settlement credit score impact.
What Is Debt Settlement?
Debt settlement is the process of negotiating a lower payment than what you owe on unsecured debts. The process can take several months or even years, but the financial benefits can go beyond your credit score and make it easier to breathe easily again.
What’s more, working with a debt settlement firm to resolve your debt can minimize the impact of the settlement process on your credit score and the credit reporting by your creditors.
In many cases, you’ll stop making payments on to your credit card company during the debt settlement process. When working with a debt resolution law firm, you’ll make payments into a settlement account, which the firm will use to negotiate with the creditor once the balance is enough to do so.
If the lender agrees, you’ll settle for less than what you owe and can move on without the burden of that debt. But while debt settlement can be a good move, it’s important to know about its impact on your credit.
What Are Collection Accounts?
Collection accounts are unpaid debts that have been sent to the original creditor’s internal collections department or a third-party debt collection agency. These accounts typically appear on a person’s credit report and indicate that the original lender, such as a credit card company or medical provider, has given up on collecting the debt directly. Instead, they have transferred or sold the debt to a collection agency, which then takes over the responsibility of recovering the owed amount.
How Does Debt Settlement Affect Your Credit Score?
First, it’s important to understand that your credit score can go down whether you participate in a debt settlement program or not. In fact, if you’re already behind on payments, much of the damage may have already been done.
That’s because “payment history” is the most significant factor in your FICO score, accounting for about 35% of it. If the debt was already delinquent before the settlement, those missed payments would have already affected your score. The settlement adds another layer of negative information, further lowering your score.
Because you may have to stop making your payments on your credit cards, debt settlement results in a temporary negative impact to your FICO credit scores and other types of scores. But if your credit score isn’t that high because you’re already behind or for other reasons, the drop due to the debt settlement process may not be very dramatic.
Additionally, settled accounts will remain on your credit report for seven years from the original delinquency date. This means that your credit history could be impacted by your decision to settle for many years to come. However, credit scoring models favor new information over old, so if you can manage to develop good credit behaviors going forward, the good can outweigh the bad.
Unfortunately, it’s impossible to say exactly how debt settlement will impact your credit score because there are a lot of different factors that go into a credit score, including:
- how much credit card debt you have
- what your payment history is like
- how high your credit limit is across all of your credit cards
- the total of each credit card balance
- what information each of the three credit bureaus has about your credit profile
- how much outstanding debt you have
- how long you’ve missed making monthly payments
Everyone’s credit score is different. For one person, debt settlement could just cause a fluctuation of a few points, and for another, it could be 20 points or more. But in the end, you will be out of debt and into cash flow positive, which is the big-picture goal for personal finance management.
Will Paying off Collections Improve Credit?
Think of it like this: To get ahead of the debt cycle and get out of debt, you might have to take one step back to take two steps forward. Yes, your credit score can go down by working with a debt settlement company or law firm, but in the long run, you will resolve these debts, which can increase your score and creditworthiness for the better.
It has to be done carefully and by a professional law firm experienced enough to understand credit, debt, and the impact of debt settlement on your credit score.
Also, if debt settlement is the last resort for avoiding bankruptcy, your credit score will take less of a hit going through this process than by trying to get your debts completely discharged.
Here are some ways you can work on rebuilding your credit after completing a debt settlement:
- Pay off remaining debts: Focus on paying off any remaining debts you have, starting with high-interest accounts. Consistently making on-time payments is one of the most effective ways to rebuild your credit. Set up automatic payments or reminders to ensure you don’t miss any due dates.
- Consider a secured credit card: If your credit score has taken a significant hit, you might have difficulty getting approved for traditional credit cards. A secured credit card, which requires a cash deposit as collateral, can be a good option. Use it responsibly by making small purchases and paying off the balance in full each month.
- Avoid new debt: While rebuilding your credit, avoid taking on new debt unless absolutely necessary. Focus on managing your current obligations and demonstrating responsible credit behavior over time.
- Build positive credit history: If you don’t have any active credit accounts, consider getting a credit-builder loan from a credit union or becoming an authorized user on a family member’s credit card. These options can help you add positive payment history to your credit report without going into debt.
- Be patient and persistent: Rebuilding credit takes time. Even with perfect financial behavior, it can take several months to see significant improvements. Stay patient, continue practicing good financial habits, and your credit score will gradually improve.
Is It Possible to Remove Paid Collections from Your Credit Report?
It is sometimes possible to remove paid collections from your credit report through methods like writing a goodwill letter to the creditor or collection agency, requesting the removal as a gesture of goodwill, or negotiating a “pay-for-delete” agreement before paying the debt. However, these strategies don’t always work.
You can also dispute any inaccuracies in the collection entry on your report, which could lead to its removal if errors are found.
How Long Does a Collection Remain on a Credit Report?
A collection account typically remains on your credit report for seven years from the date of the first delinquency on the original debt. The date of the first delinquency is when you first missed a payment and did not bring the account current afterward. Even if the debt is paid off, the collection account will stay on your report for the full seven years, though its impact on your credit score will lessen over time as it becomes older.
The Bottom Line
Debt settlement is never ideal, but if your situation is dire, it could be the best path forward to getting back on the right track financially. In this scenario, it may be good to view your credit score as secondary to your overall financial health.
Leaving your debts as-is can result in credit card balances growing until you max out your credit cards (or are close), which will have a negative effect on your score. Even if you take out debt consolidation loans, all debt comes with interest charges and can keep you stuck for many years. Even a balance transfer credit card—another option for dealing with debt—could hit you with high interest if you don’t pay off the balance before your 0% interest period ends.
Debt settlement may cause your credit score to decrease for a period of time, but it can alleviate cash flow so your budget isn’t so tight. A good debt management plan can make it easier to establish healthy credit habits in the future, which can have a positive impact on your finances long term.
Entering a debt settlement law firm program like Tayne Law Group’s can help you resolve your debts. What’s more, it can also help you learn to be less dependent on credit cards and loans and more dependent on budgeting and realistic money management. This way, when you finish the program, your credit score will restore itself naturally over time and will stay that way because you are no longer relying on credit cards and other forms of consumer debt.
