Key retirement financial advisor takeaways

  • Settling your car loan can hurt your ability to qualify for financial products in the future as it will lower your credit score.
  • You’ll need to pay taxes on the settled debt.
  • The car loan settlement process may help you dodge worse credit damage if it helps you avoid multiple missed payments or repossession.

Settling a car loan is a difficult decision to make. It affects your credit score and may harm your ability to get another loan or open a new line of credit. Most people want to avoid an auto lending settlement. But sometimes, there is no other viable option.

Settling a car loan requires connecting with your lender directly and finding a solution. Often you will negotiate a lump sum payment that is less than the full car loan if you pay by a certain date.

Before making this decision, it’s important to understand the pros and cons for your long-term credit history and financial goals, plus your current financial situation.

Settling a car loan will lower your credit score

When you settle a car loan, the immediate impact on your credit score is negative. Your credit score will go down, but the amount it drops varies. Generally, the higher your score is at the start, the more it will go down if you settle your loan.

A settled account will remain on your credit report as a derogatory mark for seven years after the original delinquency date.

In addition to the derogatory mark, eliminating the auto loan affects your FICO score in other ways, too. Credit mix and length of credit history make up 10 and 15 percent of your score, respectively. Settling your loan changes the average length of your credit history and, unless you have another auto loan, it will reduce number of credit types in your credit mix.

Despite these downsides, settling an auto loan may be better than letting multiple missed payments piling up on your record and cause more damage.

Car loan settlement could prevent worse credit score damage

For some, settling your car loan could be your best option in the long term. Your credit score is negatively affected every time you miss a loan payment. If you struggle to make regular payments and can’t pay off the auto loan completely, settling your auto loan will allow you to start rebuilding your credit. It will also help improve your debt-to-income ratio, which can further boost your credit score.

Once the loan is settled, your credit score will initially go down — but you can then focus on building it back up. You can work to make other payments on time, pay down other debts and raise your credit score again. Opening new lines of credit could negatively affect your credit, so you may want to avoid new accounts until your credit score is in better shape.

You’ll also pay taxes on the forgiven debt

It’s worth noting that when you settle an auto loan for less than the amount of the loan itself, the creditor writes off the difference. The IRS considers that amount taxable income, which means you may have to pay federal taxes.

You should receive a 1099-C cancellation of debt tax notice from the creditor. It will inform you of how much you have to pay taxes on. Because the cancellation is taxed as income, it will be taxed at the income tax bracket that you are in.

Car debt settlement vs. repossession

Settling your car loan differs from vehicle repossession. With an auto loan settlement, you agree with the lender to pay a portion of your original debt. Your debt is then considered settled. However, you will have to pay taxes on your forgiven debt.

With repossession, the lender will take back your car and sell it to pay off some or all of your loan debt. If the car sells for less than the amount of your debt, you may still owe money to the lender. This is called a deficiency payment.

You can turn in your car and allow the lender to repossess it voluntarily. The lender may also have the right to repossess your vehicle without your consent if you fail to make your loan payments.

Both car debt settlement and repossession will impact your credit score for the worse. And, since late payments often precede both, you may have multiple negative marks in your credit history.  Repossession can drop your credit score by 100 points or more.

The best option for your credit is always to pay off your debt in full, but that’s often too tall of an ask. If you can’t do that, try to work with your lender to find the best solution. You may want to talk to a credit counselor to determine what would be best for your situation.

6 alternatives to settling your car loan

  1. Pay off the loan completely. Paying off your debt in full is always the best option for your credit.
  2. Modify your car loan. Depending on your situation, you may be able to modify your car loan. Talk to your lender to find out if it can help rework the terms of your loan.
  3. Trade in your car. If your car loan is too expensive, consider trading in your car for an older vehicle. This could get you a lower monthly payment for your vehicle loan.
  4. Sell your vehicle. If you can get around without a vehicle, even temporarily, you may want to think about selling your car.
  5. Allow your car to be repossessed. Vehicle repossession also negatively impacts your credit, but it is still an option. Talk to a credit counselor to find out the best options for your credit.
  6. File for bankruptcy. If your car payment isn’t your only financial issue, you could file for bankruptcy. This will affect your credit for up to 10 years, so it’s not something you want to do if you have other options.

The bottom line

Settling a car loan can be intimidating, but improving your situation now will improve your finances in the long run. Consider your alternatives before settling your car loan, as it will affect your credit score negatively for seven years. If you aren’t sure what to do, consider talking with a credit counselor.