Negotiating a debt settlement may have consequences that are just as troublesome as the debt burden. The credit scoring formula used by most lenders punishes consumers when they force the creditor to cancel debt. Also, canceled debt may not be the final action on your loan, because the Internal Revenue Service usually considers this a taxable event.
Effect
Canceled debt negatively affects credit when the lender reports the account as settled for less than the original balance to the credit reporting bureaus. A settled account can take 125 points or more off of a FICO credit rating of 780, according to Ellen Cannon of Bankrate.com. If your credit is already damage, the impact won't be as much, but any settled account is still a derogatory item on a credit history.
Taxes
The IRS taxes canceled debt because it views a forgiven debt as akin to receiving income. If you could not pay the original balance in full, you may not have the resources to pay the IRS come tax time. Unless you set up an installment agreement, the IRS issues a tax lien against your property when cannot pay your bill. Any IRS lien or levy damages your credit rating---maybe up to 100 points or more.
Considerations
Letting a creditor cancel a debt may become an overall benefit to your credit rating. Frequently missing payments keeps your credit rating low for years to come. In addition, you free up more monthly income that can go to paying your other debt obligations and help you avoid a more serious derogatory item on your credit history, like bankruptcy.
Tip
You can ask the lender to report the account as paid in full in debt settlement negotiations, but lenders are unlikely to concede this provision unless you pay the balance in full. If you worry about the effect of canceled debt on your credit rating, talk to the lender about ways to avoid default, such as repaying the loan in installments or lowering the interest rate.
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