If you’re struggling to afford your bills or have already fallen behind, you might want to look into debt settlement as a way to get back on your feet. With debt settlement, your creditor agrees to let you pay less than you currently owe and cancels the remaining debt.
Even if they don’t get the full amount, settling an account could be more cost-efficient for creditors than paying debt collectors to go after you, or suing you for the unpaid amount. However, creditors might not consider settling a debt unless you’re behind on your bills or experience a major change that will affect your ability to pay the debt, such as an accident that leaves you with a disability.
When you settle an account, a special comment will be added to the account on your credit report that indicates you paid less than the full amount. Debt settlement isn’t good for your credit scores because you’re paying less than the amount you agreed to repay, but it may be better than having an unpaid account that’s past due or in collections.
How settling debt will affect your credit
Once you settle an account, the creditor or collection agency should send an update to the credit bureaus (Experian, Equifax and TransUnion) telling them that the account was paid in full for less than the agreed amount. The remaining balance will also be updated to zero.
The effect on your credit scores will depend on the type of credit scores. The most recent FICO Score versions 9 and 10, along with the most recent VantageScore versions 3 and 4, ignore collection accounts with a zero balance — including the accounts you settle. However, older scoring versions, such as the widely used FICO Score 8 and even older FICO models that the mortgage industry uses, still consider settled collection accounts.
The settled accounts will also stay on your credit report, and an account’s payment history, age and other information can affect your credit scores until the account is removed. If the account was past due when it was closed, the entire account falls off your credit report seven years after the initial late payment that led to the closure. But if you brought the account current before it’s closed, it will stay on your credit report for 10 years after it’s closed.
Not all credit scores are created equally. Here’s the difference between a FICO Score and a VantageScore
How does debt settlement work?
The debt settlement process can depend on the type of debt, your financial situation and the creditor. Generally, debt settlement it’s only an option with unsecured loans, such as credit cards and personal loans. These don’t have collateral, which means the lenders have few options if you don’t repay the debt.
One option is to report late payments, charge-offs and collection accounts to the credit bureaus, which can hurt your credit score. They can also start making collection calls and texts, or sue you and try to garnish your wages or bank account. But running collection operations can be costly, and lawsuits can cost even more time and money.
Often, people will ask for a settlement when they’re struggling with their bills or already far behind on payments. You may need to offer the creditor a lump-sum payment or agree to pay off the settlement amount over time. And there may be some back and forth as you decide on an appropriate and manageable amount and payment plan.
There are also debt settlement companies that will offer to help you settle your debts. They may have experience negotiating with creditors, but proceed with caution: Many companies advise you to stop making payments on your accounts to put pressure on your creditors to agree to a settlement. This can cause further harm to your credit.
Late payments can hurt your credit score and your accounts may be accruing more interest and fees. And there’s no guarantee the settlement will save you money overall — especially once you include the debt settlement company’s fees. There have also been cases of people or companies who can claim to help you with debt settlement that wind up being complete scams.
Considering a DIY approach to debt settlement? Here’s how to negotiate it yourself.
What debts should you settle?
Debt settlement might be an option on your unsecured credit cards, loans and lines of credit if you’re behind on your bills. When you owe back taxes, the IRS may also accept an offer in compromise — a settlement for less than you owe. However, you’ll need to meet the IRS’s eligibility requirements, and the settlement amount may depend on your financial situation.
What debts can’t you settle?
It can be much harder to settle secured debts, such as auto loans or mortgages. Before agreeing to a settlement, your creditors can repossess or foreclose on your car or home and sell it to cover your unpaid debt. If there’s still a balance left over, you can offer a settlement for less than that amount.
You also might not be able to settle other types of debt, such as student loans. However, recent changes in the law might make it easier to cancel student loans if you file for bankruptcy.
Alternatives to settling debt
Debt settlement isn’t the only option if you’re struggling with your bills, and other routes might hurt your credit less and even offer more savings:
- Creditors’ hardship options: You can reach out to your creditors, explain why you’re struggling with payments and ask if they have any hardship programs. Try to do this as early as possible — ideally before you miss a payment. There aren’t any guarantees, but creditors might offer to lower your minimum payment, miss payments without hurting your credit or temporarily lower your interest rate.
- A debt management plan (DMP) from a credit counselor: A debt management plan (DMP) is a program offered by credit counseling agencies. With a DMP, a credit counselor will negotiate with your credit card issuers (and sometimes other lenders) to lower your interest rate and minimum payments, waive fees and bring past-due accounts current. DMPs can often help people pay off the included credit card debts within three to five years. And although the counselor might charge a fee for the DMP, you can often save even more on interest and waived credit card fees.
- Bankruptcy: Although it’s often a last-resort option, filing for bankruptcy could also help you quickly discharge unsecured debts or get on a more manageable payment plan with your creditors. A bankruptcy filing can hurt your credit and stay on your credit report for seven to 10 years, but it might still be the best option.
You also might be able to get your finances back on track by following a budget and finding ways to save (or earn) more money. Debt payoff strategies, such as the debt snowball or avalanche approaches, can help you decide which debts to focus on first. If you have good credit, you might also qualify for a debt consolidation loan — a personal loan with a low interest rate or monthly payment that you can use to pay off higher-rate credit card balances.
Struggling with debt? Consider credit counseling to help you find a path forward
Frequently asked questions (FAQs)
Settling a debt will generally help your credit a little, although not as much as paying your bills in full. However, if you intentionally stop making payments on an account that’s current or only slightly past due, that could significantly hurt your credit scores in the meantime.
Once you settle a debt, it’s considered paid, the balance will go to zero and you don’t have to worry about additional collection calls or lawsuits. Although you may have to pay income taxes on the canceled debt, settling debts can help you save money compared to repaying the debt in full. It can also be a worthwhile option if you have an account in collections that’s keeping you from qualifying for a mortgage or other type of credit account.
Regardless of whether an account is settled or not, a closed account can stay on your credit report for up to ten years if the account is current when it’s closed. However, settled accounts are often past-due when they’re closed. In that case, the account and connection collections accounts will fall off your credit report seven years after the first late payment in the series that led to the closure.
