If You Settle a Debt Does It Affect Your Credit?
Understand the real impact of debt settlement on your credit standing and financial future.
Debt settlement involves an agreement with a creditor to resolve a debt for less than the full amount originally owed.
Understanding Debt Settlement
Debt settlement involves negotiating with creditors to pay a single lump sum to satisfy an outstanding balance. This strategy is for individuals facing significant financial hardship who cannot manage their existing debt. It differs from paying off a debt in full, where the full amount is repaid. Debt settlement also stands apart from debt consolidation, which combines multiple debts into a single loan, often with a new interest rate, without reducing the total amount owed.
The process occurs after a debt becomes delinquent or is charged off by the original creditor. Creditors may consider settlement offers when it appears unlikely they will recover the full amount, especially if bankruptcy is the alternative. Debt settlement companies often advise individuals to stop payments and save funds into a dedicated account for the lump-sum offer. This provides leverage in negotiations, as creditors may prefer a partial payment to none.
Credit Report Appearance of Settled Debt
When a debt is settled for less than the full amount, it appears on a credit report with a specific notation. This status might be listed as “settled for less than the full amount” or “paid in full for less than the full balance.” These notations differentiate settled debts from accounts paid in full, which reflect that the borrower met all original terms.
Before a settlement is finalized, the account may first be reported as “charged off” by the creditor. A charge-off occurs after prolonged delinquency. Both the charge-off and the subsequent settlement notation are considered negative marks on a credit report. These negative marks, including delinquencies, charge-offs, and the final settlement status, can remain on the credit report for up to seven years from the date of the original delinquency.
Impact on Your Credit Score
Settling a debt for less than the full amount negatively impacts credit scores. Credit scoring models, such as FICO and VantageScore, view this unfavorably as it indicates the borrower did not fulfill the original credit agreement. This differs from accounts paid in full, which reflect positive management of obligations.
Debt settlement significantly impacts primary credit score factors like payment history and amounts owed. Missing payments or a charged-off account negatively affects payment history, a substantial component of credit scores. Even with a zero balance, the unpaid debt affects the “amounts owed” category. The severity of the score drop depends on prior credit history, debt amount, and delinquency duration. While settling a debt is typically less damaging than a complete default or bankruptcy, it still results in a considerable reduction in credit scores compared to paying the debt in full.
Post-Settlement Credit and Tax Considerations
After a debt has been settled, monitoring credit reports is important for accuracy. Consumers should verify the settled debt is reported with the correct “settled” status and any inaccuracies are addressed. This review helps confirm the information on credit reports aligns with the settlement agreement.
Although the negative entry persists, its impact on the credit score generally diminishes over time, especially if positive credit habits are established afterward. The account closure that often accompanies settlement also plays a role in how it is viewed by credit scoring models over the long term.
Tax implications are a significant consideration following debt settlement. When a creditor forgives a portion of a debt through settlement, the forgiven amount may be considered taxable income by the Internal Revenue Service (IRS), known as Cancellation of Debt (COD) income. Creditors must issue Form 1099-C, Cancellation of Debt, to the debtor and the IRS if the forgiven amount is $600 or more. Exceptions to COD income, such as insolvency or bankruptcy, may exempt the taxpayer from including the forgiven amount in gross income. Consulting a tax professional is advisable to understand specific tax consequences.