Does It Affect Credit Score if You Settle for Less Than You Owe?

When you are late on payments for a debt, the lender is sometimes willing to accept a settlement. This is when you pay a lump sum that is less than what you owe, but the lender stops pursuing you for further repayment. This might seem like a good deal, but has negative effects on your credit score that hurt you in the long run.

Credit Reporting

Information that appears on your credit report has the potential to affect your credit score. One thing that lenders report is when you settle an account for less than you owe. The exact wording varies depending on the lender and the credit bureau, but the account is usually listed as "settled" or "partial payment accepted." Regardless of the terminology, when an account appears on your credit report as having been paid for less than the amount due, this is bad news for your credit score.

Impact in Points

Your credit score will probably decrease by somewhere between 45 and 125 points after a debt settlement appears on your credit report. The missed payments leading up to the settlement will also damage your score. The exact impact depends on what your score was before the settlement. The higher your score was before, the more points you will lose. If you already had quite a bit of negative information on your report, one more item will not make as big of a difference.

Time Frame

Negative information on your credit report affects your score for up to seven years following the event. However, over time, the negative effect diminishes. If you manage credit well after your settlement, you should be able to bounce back within a year or two. Some ways to improve your credit score are to have credit cards with a high percentage of available credit, to make payments on time and to avoid applying for credit more than once or twice a year if possible.

Tax Implications

Debt settlement does not only affect your credit score, but it can also affect next year's tax return. The federal government considers your forgiven debt to be taxable income. For example, if you owed $8,500 on a credit card and reached an agreement to settle for $5,500, the lender forgave $3,000 of debt. When you file next year, you have to include this $3,000 in your income and, unless your deductions outweigh it, you will have to pay income tax on this money.