Does Settlement Less Than Owed Affect Your Credit Score?

Paying a creditor or lender less than you owe on a debt may seem like a good option if you're having financial troubles. However, debt settlements reduce credit scores, and a low score will make it difficult for you to get credit cards and loans in the future. Ultimately, the money you save through a debt settlement could cost you more than you anticipate.

Scoring Models

Notations such as "settled account" and "settlement" appear on credit reports when consumers dont pay credit and loan accounts in full. In turn, all credit-scoring models will give a negative rating to those accounts, according to Bankrate.com writer Leslie McFadden. Furthermore, McFadden indicates that a settlement on a delinquent account could affect your credit score in the same way debts do when theyre included in a bankruptcy because both settlements and bankruptcies cause creditors and lenders to endure a financial loss.

Credit Scores

Debt settlements don't affect credit scores in the same way, since consumer credit histories vary. However, the higher a person's credit score is, the more damage a settlement can do. Fair Isaac Corporation manages the FICO credit-scoring model, and the company's website provides a scenario that demonstrates how much debt settlements can affect consumer credit scores. Someone who has a FICO score of 780 could see his score drop as much as 125 points after settling a credit card debt, according to Fair Isaac. Another person who has a score of 680 may lose up to 65 points for paying less than the full amount to settle a credit card debt.

Payment Plans

You may reduce the amount of credit damage a delinquent debt causes if you negotiate a payment plan with the original creditor to pay the debt in full. The FICO credit-scoring model places more weight on what the original creditor reports about a consumer than what a collection company reports, according to MSN Money columnist Liz Pulliam Weston. Therefore, working with the original creditor to pay a delinquent debt in full before it goes to a collection agency may cause less damage to your credit rating. You also would benefit because the creditor would eventually report to credit bureaus that the account was paid in full, not settled.

Considerations

The consequences for not paying a debt in full may not end with a damaged credit rating if the amount of debt you don't repay in a settlement exceeds $600. The Internal Revenue Service generally considers debt that creditors and lenders forgive as part of a taxpayer's taxable income, which could increase a person's tax bill. Creditors and lenders usually must report the amount of the canceled debt to the IRS. Taxpayers who can show they can't afford the additional tax liability may be able to get it waived by filing IRS form 982.