Debt settlement can be a solution to reducing the amount of money you owe. The process of settling your debts involves contacting your creditor -- or hiring a settlement company to do this on your behalf -- and asking the creditor to accept a percentage of what you owe as payment in full. Because debt settlement involves the forgiveness of some of your debt, you cannot use debt settlement without some harm to your credit score. However, debt settlement sometimes is the best way to get back on your feet financially.
FICO Scoring
Your Fair Isaac Corporation (FICO) credit score is calculated based on many factors, including, among other things, your length of credit history, amount owed (your debt-to-credit ratio) and payment history (whether you have paid bills on time). Generally, using debt settlement impacts your credit score negatively in terms of the length of your credit history. However, with debt settlement, you eliminate some of the delinquent debts tracked in the payment history category of your FICO score. With these debts cleared, credit scores sometimes rise with the use of debt settlement. Payment history makes up 35 percent of the credit score calculation, while credit history length makes up only 15 percent.
Why Your Credit Suffers
When you opt for debt settlement, your creditors typically end up closing your account once you pay the arranged amount. Closing an account can shorten your credit history, because history is calculated using only open accounts. This, in turn, lowers your credit score. As a result, debt consolidation companies and other financial advisers, such as Debt Settlement Outlet and Dr. Don Taylor of Bankrate, recommend keeping older accounts open even if the balance on those accounts is zero.
Length of Impact
Generally, a settled debt may remain on your credit history for up to seven years. During that period, you should do everything you can to make the rest of your credit score as clean as possible. Obtain a free copy of your credit report each year through AnnualCreditReport.com to check your financial activity and dispute any inaccuracies that are negatively affecting your credit score.
Considerations
Debt settlement does lower your credit score somewhat, but the impact of settlement is not as severe as some other methods of dealing with debt. For example, bankruptcy means a creditor may get no payment at all, whereas a settlement provides the creditor a portion of what you owe. Because debt settlement reduces the amount you owe, the negative impact on your credit is partly offset by your ability to make other payments on time. Over time, the lack of delinquencies will rebuild your credit score. Additionally, settlement doesn't necessarily destroy your credit. In some cases, your credit score after a debt settlement may still qualify you for some loans. Also, you may ask your creditor to upgrade your account rating that is reported to the credit bureau. Creditors can list your credit rating anywhere from R1 to R9 on an account. R1 is the best rating possible and represents paying in full on time. R9 is the worst, representing bad debt, bankruptcy and other collections. Creditors also can use specific wording, such as "settled" or "settled in full," and they may upgrade your account to "paid in full" in rare instances. Such designations may help a potential lender view your credit report more favorably. The decision to change the account rating ultimately is up to your creditor, and not all creditors will upgrade account ratings based on your request.
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