The Negative Effects of Debt Settlement on a Credit Score

Settling a debt for less than its full balance can wreak havoc on your credit score. There are, however, situations when debt settlement does not, by itself, decimate your score. Unfortunately, in these situations, your credit score has already been damaged severely. Settling debts for less than full balance is good news for your bank account, but highly credit score unfriendly, as these arrangements are displayed on your credit report.

Debt Settlement

Understand that debt settlement is different from credit counseling and restructure. If your financial condition becomes insufficient to make all necessary debt repayment, either you or a credit counseling company can restructure your payment levels to fit your challenged budget. Debt settlement, however, forces the creditor to accept less than full balance payment but acknowledging that your debt is "paid off." Your credit report will show that the debt was "settled for less than the full balance."

Damage to Credit Score

Debt settlement actions will severely damage your credit score when your accounts are up-to-date or only slightly delinquent -- about 30 to 45 days behind. Your credit score will take a huge hit. While your score decrease will be less damaging than a recorded "charge off" of the outstanding balance, the decline will be significant. Your creditor lost money. You could argue that they accepted this arrangement, which they did. However, other lenders also understand that these creditors had no choice but to accept a short pay-off.

Little Credit Score Damage

When your credit score is not severely damaged by a debt settlement, this is not really good news for you. The only time settling a debt does not materially affect your credit score is when you are already very delinquent -- 90 days or more -- and your score has already been decimated. Once again, a settlement is better than forcing the creditor to write off your entire balance. However, a debt settlement will still decrease your credit score. A major delinquent status has already seriously lowered your credit score, so a settlement will result in a lesser decrease.

Rebuilding Credit

It is impossible to give all-encompassing answers to questions about the timing to rebuild credit. Credit score calculations use many factors in a complicated mathematical algorithm to arrive at your number. For example, if you had nine credit sources and had to settle only three at less than full balance, your score will recover much faster than if you had to settle all nine creditor balances. However, your settlement results will remain on your report for up to seven years after settlement date. Your creditors could voluntarily choose to mark your account simply as "paid," but these cases are rare.