Adverse credit report entries generally remain for seven years; however, the negative impact should decline over time. If other reported accounts are current and remain in good standing, substantial improvement is attainable in under one year.
When credit reports contain other negative entries, rebuilding will likely take several years, but remaining current on all existing accounts and seizing opportunities for establishing and building new credit can help expedite the process.
How Does Debt Settlement Work?
Debt settlement companies, also commonly called debt relief agencies, negotiate with creditors on behalf of struggling consumers. The most common strategy involves reaching an agreement that “settles” the account with a lump sum payment that is lower than the total balance.
According to Experian, settlement agreements commonly involve paying an amount that is reduced by 20% to 50%. Because a debt settlement results in not paying the balance in full, it will negatively impact your credit.
Additionally, late payments often accumulate during the negotiation process, which may worsen your credit score. Debt settlement companies often encourage halting payments as a means of motivating the creditor to consider a reduced settlement amount.
Most settled debts involve unsecured debt such as credit cards where the lender lacks leverage in the absence of any collateral (assets) backing the loan.
For example, lenders have more leverage with secured debts such as auto loans or home mortgages, where these assets may be repossessed and used for recouping losses.
From the creditor’s view, settling the account for a lesser amount represents a much better option in comparison to receiving nothing.
Although laws exist prohibiting a debt settlement company from imposing upfront fees, they typically require compensation equivalent to a percentage of the settlement amount or a percentage of the reduction achieved.
The fees charged by many national debt relief providers often reach 20 to 25%. For example, if a $20,000 account resulted in a debt negotiation of only $10,000, the consumer would pay $2,000 to $2,500 in debt settlement program fees.
Some consumers engage in “do-it-yourself” negotiations with creditors as an alternative to working through a professional debt settlement agency and incurring the applicable fees.
How Does Debt Settlement Affect Your Credit?
The National Foundation for Credit Counseling (NFCC) states that forgiven debt settlement plans may “wreak havoc” on credit scores. Further, the NFCC explains that each missed or late payment that occurs amid negotiations or while gathering up a lump sum worsens credit scores.
According to TransUnion, a consumer’s credit history with the credit reporting agency (aka credit bureau) will often list settled entries as “settled for less than full balance” or a similar description with a negative connotation or undertone.
Regarding the resulting bad credit, settlements could reduce your credit score by over 100 points, which likely remains higher than if you had multiple accounts in debt collection that ended in bankruptcy.
Keep in mind that your credit utilization rate could also drop, particularly when credit card debt settlements result in formally closing the credit account. Credit utilization rates measure the percentage of your overall available credit that is currently in use, which we’ll discuss more later on in the article.
Generally speaking, anything less than 30% is considered a good credit utilization rate while 10% or less is the most ideal.
As it pertains to how settled debt arrangements translate to bad credit, Experian makes a distinction between these debt relief solutions and debt management plans, which are also commonly referred to as credit counseling programs that might involve debt consolidation.
Here, the credit counseling firms usually negotiate with issuers of credit cards or other credit accounts for reducing interest rates or lowering monthly payments. This process generally has a less adverse impact on credit scores because the principal amount (balance) is still paid.
How Long Does It Take to Recover from a Debt Settlement?
The duration needed for rebuilding credit after the settled debt payment process may vary. One consideration involves your new credit score, which basically represents the starting point as you enter the credit repair process to improve the status of your credit rating.
Although most individuals who complete a settled account will likely have a below-average or bad credit score, those with other existing credit accounts in good standing generally are best positioned for swiftly restoring their credit history and achieving a good credit score.
Those with other existing accounts, such as credit cards or personal loans, will continue making timely payments and more rapidly improve their bad credit history. Similarly, those with a long, mostly positive credit report often experience credit repair in less than six months.
Consumers seeking to rebuild their bad credit should begin taking positive steps—like those that experts often recommend after emerging from bankruptcy.
For example, paying all bills on time, finding the best credit cards for those with poor credit scores, or pursuing a credit builder loan. In most instances, reasonable expectations for a post-debt settlement recovery range from approximately 12 to 24 months.
Is Debt Settlement Worth It?
A recent study indicated that the average consumer saved $2.64 for each dollar imposed in fees by debt settlement companies. Determining whether a settlement arrangement is “worth it” is potentially subjective and based on individual circumstances.
Freedom Debt Relief, among the nation’s largest providers of debt settlement services and debt consolidation loans, explained some of the common distinctions between debt settlement and common alternatives. Some of their findings revealed the following:
Pros
- Unlike some alternatives that reduce interest rates, debt settlements will reduce the principal balance owed.
- Debt consolidation loans often come with higher fees and processing costs.
- Financially, debt settlement agreements commonly rival or surpass the savings achieved under Chapter 13 bankruptcy without enduring the more devastating impact on your credit score.
Cons
- Most negotiation attempts involving secured debts including vehicle or mortgage loans prove futile.
- Expect creditor or collection agency calls after due dates pass, which is usually necessary for reaching the negotiating table.
- During the process, creditors may bring a civil action to recoup lost compensation.
- The potential tax liability (discussed below)
The Internal Revenue Service (IRS) may pursue taxes based on the savings (difference) between the amount of the debt owed and the negotiated settlement amount that was actually paid if it exceeds $600.
From a broader perspective, substantial financial problems already exist when consumers either as individuals or in families deem it necessary to enter settlement agreements with professional debt relief companies or most other alternative options.
Therefore, many of these are reactionary or remedial measures primarily focused on minimizing the damage.
Conversely, while also neutralizing the impact of existing negative credit reports, more proactive credit-building options have a positive effect that may expedite the rebounding process.
How to Rebuild Credit After a Debt Settlement
Regardless of the outcome of debt settlement efforts, damaged credit is a likely result. Fortunately, several basic recovery strategies exist.
Use a Credit Builder Loan
As a division of Austin Capital Bank in Texas, CreditStrong is a pioneering organization that provides credit builder loans. As a type of installment loan, a credit builder loan deposits the loan funds into a savings account for the duration of the term.
The borrower makes an affordable monthly payment each month toward the balance. Meanwhile, CreditStrong regularly reports loan activity to the three major credit bureaus, which then improve your credit score.
After all the loan payments are paid in full, the funds in the savings account are released and available for the borrower.
Don’t Miss out on Making Timely Payments
The Fair Isaac Corporation (FICO) is a leader in creating models that calculate FICO credit scores. According to FICO, the largest single factor that influences these calculations is payment history—equating to roughly 35%.
Lenders recognize the correlation between a borrower’s past payment history and the likelihood of future financial behavior; therefore, taking steps to get organized and ensuring timely payments is a critical practice.
Maintain a Healthy Mix of Credit
To a lesser extent than payment history, FICO score calculations consider whether consumers demonstrate responsibility using two or more different types or categories of credit accounts such as installment loans like car loans and revolving accounts like credit cards.
This “credit mix” influences 10% of your score.
Check Your Credit Reports Regularly
Consumers are eligible to receive a free copy of their credit report each year from Experian, Equifax, and TransUnion. With easy online access to an electronic copy of your credit report, the process is quicker and easier than ever.
Closely reviewing the contents of your credit report annually is a strongly recommended practice that can identify errors that might adversely affect your credit, detect any possible instances of fraud, and is helpful with tracking progress when seeking to improve your score.
Dispute Any Errors on Your Credit Report
As you review your credit report, promptly address any potential errors that exist.
Today, the credit bureaus each have easy-to-use website applications for formally disputing credit report entries, which may or may not also involve notifying the original creditor or collection agency. Keep in mind that submitting any supportive documentation is important.
Keep a Low Credit Utilization Ratio
Remember, the formula for calculating a consumer’s credit utilization rate is:
Credit Utilization Ratio = Total Current Debt / Total Available Credit
Consider the following example:
The consumer has two credit card accounts with combined balances of $400, each with a maximum credit line (limit) of $1,000.
$400 / $2,000 = .20 or 20%
The rule of thumb is to maintain a credit utilization rate (ratio) below 30%. Lenders recognize that consumers with credit card balances approaching the limit might be overextended and experiencing some type of financial difficulty.
Consumers facing credit-related challenges that might consider pursuing a debt settlement program should do their homework and compare the various plans offered by professional settlement companies. Assess the fees imposed, reputation, and any potential alternatives.
The good news for those struggling with paying their debts or those with past credit problems is that you can recover.
For example, taking some positive steps by avoiding large, unnecessary credit card purchases, creating a written budget, paying all bills on time, and considering some credit-building options is a good start!
FAQs
How Long Will Debt Settlement Stay on Your Credit Report?
Most negative credit entries reported to credit bureaus remain visible and impact your credit score for seven years, except for a Chapter 7 bankruptcy, which extends for 10 years.
The debt settlement typically generates two or more types of adverse credit report entries. One occurs after agreeing and paying off the settlement amount, the account description on your credit report might change to “paid for settled amount” or something similar.
Here, the description has a somewhat negative connotation compared to “paid in full” or a similar description. This results from failing to pay the full account balance as stated in the terms of the agreement.
The debt settlement process will also likely result in late or missed payments being reported. This occurs because many creditors will not engage in negotiated settlements until an account has become delinquent, which is an indicator of risk for default.
With credit card debt settlements, the account might soon close or otherwise become inactive, which reduces your overall available credit limit. This may inflate your credit utilization rate to unfavorable levels, such as a rate exceeding 30%.
How Long Does Debt Settlement Affect Your Credit?
Although all negative credit entries remain for at least seven years, the impact of these reporting entries usually diminishes over time. Depending on the circumstances, a debt settlement often results in a credit score drop of 100 points or more initially.
As the years pass, the debt settlement becomes less consequential in the scoring calculations. Keep in mind that those with an otherwise good credit history might experience a less dramatic impact such as a 100-point decline from 780 to 680, which is still a mid-range score.
Meanwhile, you might begin building credit with other types of loans or financing that offset prior declines in your credit score.
CreditStrong helps improve your credit and can positively impact the factors that determine 90% of your FICO score.
