How will debt settlement affect my credit score?

In general, debt settlement typically has a negative impact on your credit score. The exact impact depends on a multitude of factors: the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled, whether or not your settled debts are presently in good standing, how much less than the original balance the debt is settled for, and a multitude of other variables.

Why should that be, when you're lightening your total debt load and your creditors are getting some money? It's because strong credit scores are designed to reward those accounts that have been paid on time per the original credit agreement before being closed. A debt settlement plan – in which you agree to pay back a portion of your outstanding debt – by nature modifies or negates the original credit agreement. When the lender closes the account due to a modification to the original contract (as it often does, after the settlement's complete), your score gets dinged. Other lenders are likely to take notice and be more wary about granting credit to you in the future, too.

Still, it is possible that the reduced debt burden is worth a subsequent drop in your credit score. The high credit card account balances and late or missed payments (and if you are considering a debt settlement, it is generally because you are already far behind) have probably already dented it somewhat. Your credit report reveals a history of each account, including whether payments were made on time, original terms on the loan agreement and other information about how you maintained the account; each late payment is recorded).

Since most creditors are unwilling to settle debts that are current and serviced with timely payments, you're better off trying to work the deal with older, seriously past-due debt, perhaps something that's already been turned over to the collections department. It sounds counter-intuitive, but generally your credit score drops less as you become more delinquent in your payments.

You can negotiate a debt settlement arrangement directly with your lender or seek the help of a debt settlement company. Through either route, you make an agreement to pay back only a portion of the outstanding debt. If the lender agrees, your debt is reported to the credit bureaus as "paid-settled." While this is better for your report than a charge-off (it may even have have a slight positive impact if it erases a severe delinquency), it does not bear the same meaning as a rating that indicates that the debt was "paid as agreed." The best-case scenario is to negotiate with your creditor ahead of time to have the account reported as "paid in full" (even if that's not the case). This does not hurt your credit score as much.

• Settling multiple accounts hurts more than settling just one.
• As with all debts, larger balances have a proportionately larger impact on your credit score. If you are settling small accounts – particularly if you are current on other, bigger loans – then the impact of a debt settlement may be negligible.
• If you have an outstanding debt that was sent to collectors three years ago, paying it off through a debt settlement could reactivate the debt and cause it to show as a current collection. Be sure to get this straight with your creditor before finalizing any agreement.
• In your credit history, the most weighting is given to payment history, with current accounts impacting the most. If you are behind on other debts, it is important to try first to keep a newer, current account in good standing before attempting to rectify the situation of a long-overdue account. For example, if you have an auto loan, a mortgage and three credit cards, one of which is over 90 days past due, do not attempt to settle that debt at the expense of falling behind on your other obligations. One unpaid account is better than having late payments on multiple accounts.

Facing past due debt can be a scary situation, and you may feel like doing anything necessary to get out of it. In this situation, a debt settlement arrangement seems like an attractive option. From the lender’s perspective, arranging for payment of some, but not all, of the outstanding debt can be better than receiving none. For you, a debt settlement packs a mighty punch against your credit report, but it can let you resolve things and rebuild.

Consider the opportunity cost of not settling your debt. If you do not settle, then your score is not hurt right away. However, not settling might lead to continued late payments, default and credit collection attempts. These may end up hurting your score more in the long run. Sometimes, a clean slate is worth the cost.

For related reading, see "A Guide to Debt Settlement" and "Negotiating a Debt Settlement."