Will Debt Settlement Ruin My Credit?

Although paying back your debt for pennies on the dollar may sound like a scam, debt settlement is a legal solution, but not one without consequences. The creditor is likely to report to the credit bureaus that you paid the debt, but for less than what you originally owed. This could ruin perfect credit, although it has less negative impact than not addressing the debt at all. Your credit rating helps determine whether you can obtain credit and whether you get favorable interest rates on that credit.

The Damage

While debt settlement is always a negative mark on a credit report, it means less when you already have bad items on your file. A person with a credit score of 780 can expect his score to drop to the 655 to 675 range with a debt settlement, while someone with a 680 score usually ends up with a score of 615 to 635, according to Bankrate.

How Bad Is This?

When starting with an excellent credit rating -- above 760 -- you take the biggest hit, because you go from the highest range of scores to the third-best range. Creditors usually assign interest rates based on score ranges, not individual scores. If you have an average score -- around 690 -- the drop resulting from debt settlement may keep you in the same category.

Considerations

Lenders probably won't listen to a debt settlement offer unless you are delinquent on your debt. There is no reason for the bank to take a loss if you can make the payments based on the original agreement. Thus, debt negotiators may tell clients not to pay bills to force the creditor's hand. However, having seriously late payments and a debt settlement on your record probably makes you too risky for most lenders to approve you for a loan. The lender also is likely to close the account, which reduces your debt-to-credit ratio (also called credit utilization ratio) -- another part of the credit score calculation that lowers your score.

Alternative to Settlement

People drowning in debt have another option: credit counseling. This won't erase any of your debt obligations, but a counselor can try to talk a creditor into lowering your interest rate and/or monthly payment. Also, credit counseling has no effect on your credit score. Credit expert Elisabeth Leahmy of ABC News suggests you work with a nonprofit credit counselor associated with the National Foundation for Credit Counseling or Association of Independent Consumer Credit Counseling Agencies. These credit counselors are more likely to be interested in getting your finances back on track rather than collecting fees.