Debt settlement is an agreement with a creditor or debt collector to clear your debt in exchange for a partial payment—one that’s less than the full amount you owe.
Debt settlement has both pros and cons. It allows you to take care of debts you might not otherwise be able to pay off, but it damages your credit score (although not as badly as delinquent or defaulted debts). Read to learn more about how this strategy will affect you and whether it’s a good idea.
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How does debt settlement affect my credit?
Settling a debt will damage your credit and lower your credit score.
When you settle a debt, it will appear on your credit report as “settled” or (somewhat confusingly) as “account paid in full for less than the full balance.” This is in contrast to debts that you paid off normally, which are listed as “paid in full” or “paid as agreed.”
Regardless of the wording, settled debts count as derogatory marks, which are items on your credit report that hurt your credit score.
Why does debt settlement affect my credit?
Both major credit scoring models, FICO and VantageScore, penalize settled debts because they signify that you might be an unreliable borrower.
The logic is straightforward: if you recently had trouble paying a debt back in full, why would a lender want to give you a new one? After all, if you failed to fulfill your financial obligations once, it suggests that you might do so again.
The hit to your credit score reflects the risk that lenders would be taking on by extending you a line of credit.
How much will settling a debt affect my credit score?
It’s tough to predict exactly how many points your score will drop when you settle a debt. The credit bureaus and scoring companies aren’t very forthcoming on the subject, and the exact hit to your score is variable, depending on several factors (for instance, the higher your score to begin with, the larger the hit you’ll take).
In general, be prepared for a significant drop in your credit score after settling a debt—one that might be measured in dozens of points, although probably not hundreds.
That’s a big enough hit that it could drop you into a lower credit score range, i.e., to turn a good credit score into a fair credit score, or a fair score into a poor one.
Debt settlement counts as a serious black mark on your record. That’s because the credit bureaus and scoring companies want to incentivize people to pay their debts in full.
How long will the damage to my credit score last?
Like most derogatory marks, settled debts remain on your credit report for 7 years. This puts a hard upper limit on how long they can affect your score. In practice, their effect will diminish over time and will probably be negligible after 2–3 years.
Is debt settlement a good idea even though it will hurt my credit score?
Yes, despite the damage to your credit score, debt settlement can sometimes still be worth it—specifically, when it lets you clear a debt you’d otherwise be unable to pay.
Despite not providing hard numbers on exactly how much debt settlement hurts your credit, the credit bureaus are clear about one thing: it’s much better than leaving a debt completely unpaid. 1
Consequences of failing to pay back a debt
Continually failing to pay back a debt will leave a series of derogatory marks on your credit report, which may include:
- Multiple late payments: You’ll receive several of these marks, usually one every thirty days you go without paying (e.g., 30, 60, 90, 120, etc).
- A charge-off: This is a mark signifying that your lender has given up on collecting your debt and has written it off as a loss (this often happens when the debt is between 120 and 180 days overdue).
- A collection account: After charging off your debt, your lender may hire a debt collection agency to pursue you for it. This company will place a mark called a collection account on your credit report.
All of these marks will damage your credit score, and the cumulative effect will be much worse than simply settling your debt.
As far as your credit is concerned, your best option is always to pay off your debts in full, but if you’re in a deep financial hole and that just isn’t a realistic possibility, debt settlement may be the best of two (admittedly bad) options.
Other potential benefits of settling a debt
Settling your debts will also protect you from the other consequences of not paying them, such as harassment by debt collectors. In extreme cases, you can even be sued over unpaid debts, in which case the court might enter a judgment against you allowing debt collectors to garnish your wages without your consent.
You can’t be sued over settled debts, so if a debt collector threatens litigation, proposing a settlement might be a good move, even though it will temporarily hurt your credit.
How to minimize the damage to your credit from debt settlement
If you decide that debt settlement is the right move, there are two ways to go about it:
- Doing it yourself
- Hiring a debt settlement company
Either is a viable option, although whichever you choose, you should make sure you’re going about it in the right way to protect your credit (and your wallet).
DIY debt settlement
Settling your debts is as simple as reaching out to your creditor (or collection agency, if the account has gone to collections) with an offer. Do this in writing so that you have a record of your communications. You can create your offer letter with our free downloadable debt settlement letter template.
Keep in mind that proposing a debt settlement won’t do anything to “freeze” your debt or free you from your financial obligations.
While you wait for a response, the creditor or collection company is free to continue pursuing you for the amount you owe. Any payments that you miss while you’re negotiating the settlement may still damage your credit, so think carefully before you completely stop paying.
Hiring a debt settlement company
Debt settlement companies handle the process of negotiating with your creditors and collectors so that you don’t have to.
Debt settlement companies can save you time and stress, but they don’t do anything for you that you can’t do yourself, and they can’t guarantee success. Needless to say, they also cost money, which is a significant downside if your finances are in bad enough shape that you’re considering debt settlement.
Moreover, they sometimes give questionable advice. For instance, many will tell you to stop making payments on the debt you want to settle, supposedly because this will give you more leverage by making your debt collector desperate for any payment at all.
While it’s possible this will increase your negotiating power, it can also severely damage your credit score and even put you at risk of lawsuits.
If you’re planning on settling your debts by working with a third-party company, vet them carefully. Note that if you pursue DIY debt settlement instead, you can still speak to an attorney who specializes in debt if you need advice or help negotiating.
Alternatives to debt settlement
If you’re worried about the downsides of debt settlement, you do have other options. These include:
- Debt management: Debt settlement and debt management are often confused, but they’re very different. Debt management is a service offered by credit counselors. They’ll negotiate with your creditors to get you a repayment plan that fits your budget. This is a solid option for dealing with unsecured debts, such as credit card debts, and many credit counselors will offer an initial consultation for free.
- Balance transfers: A balance transfer is a transaction where you move your debts onto a credit card with a low (or 0%) interest rate. Doing this doesn’t get rid of your debts, but it does buy you some time to scrape together the money to pay them down for real. Opening a balance transfer card usually requires a good credit score, so this option is best if you haven’t actually missed any payments yet and your credit has yet to take a hit.
- Bankruptcy: This is the nuclear option. Bankruptcy is one of the most extreme credit-related actions you can take, but it provides an out for those who find themselves hopelessly in debt. If you’re really struggling to keep your head above water, you can explore this option, but consider it carefully before you commit.
- Doing nothing: While you should normally pay your debts off, there is a statute of limitations on debt, after which it’s too old to be sued over. If your debts are approaching that limit (which depends on your state), it may not be worth settling them at all, but in all other cases, you shouldn’t ignore them.
Avoid high-interest loans
There’s one option that you should steer clear of: taking out another high-interest loan (such as a payday loan) to pay off your current debts.
It’s very hard to get out of payday loan debt, and companies that offer predatory loans like this are usually less willing to negotiate than traditional lenders, so while this might provide temporary relief in the (very) short term, ultimately it will just make your situation worse.
Debt settlement vs. bankruptcy: which is worse for your credit?
As mentioned above, if you’re truly overwhelmed with debt, you might be weighing the merits of settling your debts versus declaring bankruptcy, which is a way to get out of debt without paying in full (and sometimes without paying at all).
Bankruptcy is worse for your score than debt settlement. It’s one of the single most damaging marks that can appear on your credit report.
It’s a more extreme option in other ways as well; for instance, depending on the type you file for, it may require you to sell off your possessions to pay your debts down as much as you can before they’re cleared.
Declaring bankruptcy is sometimes the right move—it’s a way to discharge or defer debts that you can’t clear in any other way. However, it’s usually better to explore other methods first and leave bankruptcy as your option of last resort if you can’t get your creditors or debt collectors to agree to a settlement or to let you clear your debts in another way.
