A short payoff or debt settlement is a type of debt-negotiation. The process allows the lender and debt holder to re-negotiate the terms of the debt. Through mutual agreement, the amount due may be reduced, fees and penalties waived, payment time extended, or interest charges reduced. The debtor may deal directly with the lender or through a debt settlement agency or a lawyer. Ideally, the refinanced deal enables the customer to gain control of his finances. In some cases, the deal negotiated may have an adverse affect on your credit score.
Credit Score Components
Credit scores use consumer debt and payment history to create a three digit score. Experian, one of the USA's three credit bureaus, lists the key elements as number and severity of late payments; type, number and age of accounts; total debt; and public records. The credit bureaus maintain the information for up to ten years after a positively maintained account is closed or for seven years after an account enters delinquency.
Impact
Lenders, auto insurance agents, and even employers use this score to assess credit worthiness. According to the New York Times, "Generally speaking, the higher your score, the more money you can borrow and the less you'll pay for the loan."
Considerations
A short payoff can have a multi-pronged negative impact on your credit score. Since accounts must be delinquent before companies will negotiate a payoff, the delinquencies will drop credit scores. When the lender writes off part of the balance due, Leslie McFadden at Bankrate.com points out, "the notation on your credit report that the account is settled (rather than paid in full) could further depress your credit score and look bad to future lenders. After all, you made a partial payment in lieu of the whole amount." Finally, in the case of credit cards, most banks' will close the account - further harming credit scores.
Prevention/Solution
Discuss impacts to your credit score directly with the lender when negotiating your payoff. Ask the lender how to reduce the negative impact to your score. According to Equifax.com, one of the most common causes of negative impacts on credit scores is late payments. Banks may honor a request to re-age the account - a process that wipes late payments off your record. Ask how the account closure will be notated. The bank may allow you to close the account, which does not harm credit scores.
Warnings
The IRS counts the amount of the debt reduction as taxable income. The amount written off must be claimed at tax time.
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