How Debt Settlement Affects Your Credit

How Debt Settlement Affects Your Credit

Debt has become a severe issue in the United States. Millions of Americans are faced with substantial credit card debt and no defined plan or method to pay it off. In some situations, a debt management plan or debt settlement program might be the best course of action. However, there are still many concerns about the pros and cons of settling debts. Many people who are looking into debt settlement are worried about the effects the settlement company’s program would have on their credit score, on top of their possibly already bad credit. Even if you have good credit, eventually your score will begin to decrease because credit utilization acts as roughly 30 percent of your credit score. The more debt you build up, the more you have “utilized” credit.  We are going to look into the effects of debt settlement on credit and whether it helps or hurts your credit. 

A Look at Credit Scores

In order to understand how credit card debt settlement affects your credit score, along with other forms of unsecured debt, it is important to have a solid understanding of what exactly your credit score represents. A credit score is a number that is used in determining an individual’s creditworthiness. In essence, a credit score serves as a utility function for both creditors and you. Lenders use this figure to assess the likelihood that an individual will repay debts in a timely manner. In fact, it is often referred to as a risk score because they assess the level of risk associated with lending to a certain person. Since credit scores affect the chances of lenders giving you credit, they are important to consider when looking at your financial life. While creditors have their own way of determining credibility, the average FICO score range is often used as an outline:

Credit Score Range (FICO)

  • Very Poor (300-579) – People who have very poor FICO scores might be required to pay a deposit or fee. In addition, these applicants are not likely to be approved for credit at all.
  • Fair (580-669) – Anybody in the fair range is considered a subprime borrower. Lenders will usually charge slightly higher interest rates on loans because they have a greater chance of defaulting. 
  • Good (670-739) – This score range is considered relatively safe for lenders. In fact, it is estimated that less than 10% of accounts will become delinquent.
  • Very Good (740-799) – Applicants with these scores qualify for better than average rates from creditors.
  • Exceptional (800-850)  – The exceptional range carries the least amount of risk and enjoys the best rates from lenders.

What Affects Credit Scores

When it comes to calculating credit scores, there are three major credit reporting agencies in the U.S. They are Experian, Equifax, and Transunion. Each one of these credit bureaus reports, updates, and stores millions of credit histories. While the information collected can vary from agency to agency, there are five factors taken into account when calculating somebody’s credit.

  • Payment history – counts for 35% of a credit score and lets debtors know if a person pays in a timely manner.
  • Total amount owed – counts for 30% and takes into account credit utilization.
  • Length of credit history – counts for 15%, with longer credit histories. The longer the credit history, the less risky you are considered to be.
  • Types of credit – counts for 10% and gives insight into what kinds of credit a person has (car loans, mortgage loans, credit cards, etc.) 
  • New credit – counts for 10%, and it takes into account the number of new accounts a person has or has applied for.

What happens to your credit when you settle debts?

Many are unsure of what effect settling unsecured debt has on their credit score. They don’t understand why it initially has a negative impact. After all, they are settling the debt, and the creditors are receiving some money. The reason your score takes a hit is that credit scores are created in a way to reward those that pay everything according to the original credit agreement. 

Debt settlement requires you to not make payments for a certain period of time. This, in turn, results in late or missed payments and high credit card account balances. As we can see from the credit factors, these are two of the biggest determinants that will have an impact on your credit score. Since debt settlement affects your initial agreement with creditors, it will likely affect your credit score.

However, it is important to note that this subsequent drop to one’s credit score is worth the reduced debt burden. In most cases, people who are considering debt settlement have had their scores affected. Getting out of debt and experiencing a temporary fall in credit might be the best course of action. In fact, debt settlement can be the exact thing you need to jump-start your path to creating a more stable financial future. Furthermore, the most recent FICO formulations are starting to emphasize debt level over payment history, so once you are out of debt after completing a debt settlement program, your credit score should heal even faster under the newest FICO calculations. Currently, not all lending institutions have adopted the new FICO method, but eventually, the majority will, as with previous FICO updates.

Better to Settle than Not Pay

While there are some negative consequences to settling an account, they outweigh those of not paying off a debt at all. If you are thinking about your long term financial standing and are concerned with major purchases, like receiving a mortgage loan to buy a home, then you must settle or pay off your debt in full, along with any outstanding delinquent debts, if you want to qualify for a loan. Also, the importance of your debt to income ratio, or how much debt you possess compared to your income, should not be understated. Many banks and lenders use this ratio as a stand-alone metric apart from credit score.

How long will a settled debt remain on my credit report?

Settled accounts are not immediately removed from credit reports. Any account that had late payment will showcase them on reports for the next seven years from the original delinquency date. If an account had no late payment, then the account will remain on the report seven years from the date it was settled. However, once an account is settled, the credit score will reflect “debt settled” or “zero balance”.

Dealing with past-due debt is a very stressful experience, especially when you are constantly receiving calls from debt collectors and card companies. Many people are willing to do anything to make the problem go away. This is why the prospect of debt settlement as a debt relief option is appealing. Creditors are willing to accept settlements because it means that they will get back a portion of their money. However, it is important to understand that your credit will take a hit in the short term. The alternative of not settling your debt can result in more late payments, defaulting, and multiple collection attempts. This can have an even bigger impact on your credit score in the long run. Consider debt settlement as a short term drawback that will enable you to fix your credit and get you back on your feet.

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