How much does debt settlement affect your credit score?

If you’re overwhelmed with debt and feel like you’ve reached your limit, debt settlement could bring some much-needed relief. But this route often comes with some negative effects for your credit that should be considered before moving forward.

How does debt settlement affect your credit?

According to former FICO’s consumer operations manager, Barry Paperno, debt settlement can affect your credit score “to the same extent as a charge-off — or an account included in bankruptcy or repossession,” meaning that the lender experienced a loss.

This will stay in your credit report for up to seven years and will be seen as a red flag by other lenders when they do a credit check. This could hinder your ability to get approved for future credit and make it difficult to secure the most favorable terms, as you will be seen as a high-risk borrower.

But debt settlement can damage your credit even before it’s completed. That’s because most debt settlement companies will advise you to stop paying your monthly payments to your creditors, as they are more likely to negotiate once you’re behind.

Payment history and credit utilization ratio make up 35 percent and 30 percent of your credit score, respectively. If you miss payments both of these components could suffer, causing your credit score to drop by over 100 points.

If the debt settlement company fails to negotiate with your creditors, you could also end up in a worse financial situation than before. That’s because you will be responsible for paying any late fees assessed by your creditors, on top of dealing with a damaged score.

How debt settlement works

Debt settlement involves negotiating with your creditors to get out of debt. Rather than paying the full amount of money that you owe, you work with a lender to settle your accounts for less than the full amount owed.

It’s possible to settle your debt on your own, going to lenders and negotiating a payment that will settle your unpaid debts and fees. However, many people opt to work with a debt settlement company. These businesses specialize in negotiating with creditors to help you settle.

The main disadvantage of working with a debt settlement company is that they often charge high fees — usually between 15 percent and 25 percent of the settled amount. But you could get out of debt in as little as two years.

If the debt settlement company is successful at renegotiating your debt with creditors, you’ll be prompted to either make a lump sum payment or stick to a repayment plan. Once you’ve completed your payments, the lender will write off the remainder of your debt and you’ll no longer owe money. As previously stated, this will have negative effects on your credit score, which will take years to rebuild.

Advantages of debt settlement

Though it will tank your credit, there are a few advantages to debt settlement.

• Get out of debt without bankruptcy. Settling debt is a way to eliminate your debts that doesn’t involve bankruptcy. That means you can avoid court proceedings and may not damage your credit quite as badly as bankruptcy would.
• Can be self driven. You can settle your debt without any help. Though many people choose to work with a company, there’s nothing stopping you from negotiating with your own creditors.
• Save money. Ideally, settling your debt will help you save money in the long run, even after fees paid to a debt settlement company.
• Stop collection calls. Settling your debt will stop debt collectors from calling you and harassing you for payment.

Which debts you should settle

To start off, you have little to no chance of settling secured debt or federal student loan debt. For secured loans, the lender can simply take possession of the collateral that you’ve offered. Federal student loans are notoriously difficult to get discharged, so lenders have little incentive to take less than the full amount owed.

That leaves unsecured debt, which includes unsecured personal loans, credit card debt and medical debt, among others. When deciding which debts to settle, focus on those that will be most difficult to pay in full, such as those that have the highest interest rates or penalty fees.

How to lessen the blow of debt settlement

Debt settlement is a difficult and risky process, but there are things you can do to soften the blow to your credit score. To begin with, you can try to take care of smaller debts on your own by consolidating or using a debt payoff strategy. Focus your debt settlement on older debt that is simply out of your reach.

You can’t begin a debt settlement until your account is delinquent, but you can time your settlement to work in your favor once you’ve reached that point. Ideally, you want to negotiate your settlement with your credit card company. This means planning to begin your negotiations while your debt is still with your original lender. This way you can avoid a charge-off, which typically occurs after 180 days of non-payment.

As you are in negotiations with your lender for your settlement, make sure you discuss how the settlement will be reported. You want it to be reported as “paid in full” and “current”. Any other reporting may cause you issues in the future.

Make sure that the account balance for the settled account is reported as $0. And anything that is agreed upon must be in writing. This will protect you if any errors are made with the amount of the settlement or how the settlement is reported.

Make sure that during this process, you have a clear understanding of your debt settlement plan. This should include a realistic starting budget so that you will be able to pay off the settlement if it goes through. Once your settlement has gone through, it is important to make your payments on time and in full to avoid future delinquencies.

How to rebuild your credit after debt settlement

Rebuilding your credit will take time after debt settlement, regardless of which methods you use.

Get a secured credit card

Though it may seem counterintuitive, getting a credit card is one way to help raise your credit score. You can open a secured credit card, which works in much the same way as a debit card.

Your credit limit will be directly linked to the amount of money you’ve deposited on the card. The difference, however, is that making purchases (and paying them off) with a secured credit card will allow you to build up your credit score again.

As you enter the world of new credit, make sure you start small. Each time you apply for credit, whether it is a loan, mortgage or credit card, the lender will make a hard pull on your credit. This will lower your credit score a bit, though the effect is ultimately temporary.

Use a program

Another way to build your credit score is to use a boost program. Experian offers a free program called Experian boost, which gives you credit for paying your phone and utility bills.

Keep old accounts open

Another way to keep your credit in good health is to keep your old accounts open. By doing so, you may be able to keep your available credit higher than your recorded debt. This also allows you to keep your average credit history up.

While the aforementioned steps will help you build your credit, ultimately maintaining good credit starts with your spending habits. To keep yourself on track financially, take some time to sit down and create a budget that works for your current income and expenses. You can use Bankrate’s home budget calculator if you need some help crunching the numbers.

Once you have your budget in place, make sure you keep up with all of your monthly payments. One way to make sure your recurring bills are paid on a consistent basis is to place them on auto payment.

The bottom line

If you’ve chosen to go through debt settlement to find relief from your debts, your credit score is going to take a hit. It will take some time to build your score back up, but it is not an impossible task. Be patient with the process, and use the tools available to you.

As you continue to work towards improving your credit score, you can keep an eye on your progress by signing up for credit monitoring. Bankrate offers a free credit report and monitoring tool to help.