Does It Hurt Your Credit to Pay a Settlement Balance on a Debt?

A settlement on a debt is a negotiated agreement to resolve a balance on a loan account. On credit cards and other unsecured debts, debtors often use settlements to pay off balances for less than the full balance. It's possible, for example, to settle a $10,000 credit card debt for $7,000 -- if the creditor or debt collector agrees. Settlements can hurt credit initially but can be beneficial for the debtor's credit in the long run.

Considerations

The three major credit bureaus -- Experian, Equifax and TransUnion -- update accounts on credit reports as "settled for less than the full balance" or a similar phrase following a settlement agreement. Settlements are a negative credit event because they show the debtor failed to pay an account as agreed. Settlements hurt credit scores and may make it difficult to obtain new credit at reasonable interest rates. The effect is greatest when the information first appears on credit reports. However, the negative impact lessens over time if the debtor pays all other bills on time and keeps revolving balances on credit cards low.

Scores

It's impossible to predict the exact effect a settlement will have on your credit. Credit scores range from 350 to 850, and people at the bottom end of the scale may not be affected at all by a settlement. That's because their credit can't get much worse. People with higher credit scores have more to lose because of a settlement.

Challenges

Usually, people engaging in debt settlement already have poor credit. Banks and credit card companies will not settle accounts that are up to date. There is no reason for them to allow a customer who is paying on time to resolve a balance for less than the full amount. However, lenders may settle with debtors who are at least three to six months behind. At that point, the lender begins to fear the debtor may stop paying on the account altogether, resulting in a bad debt. Missing payments on credit obligations hurts credit scores each month, meaning someone with credit card bills six months behind may already have credit scores near the bottom of the scale.

Credit Repair

Settling does help credit in the long run because it satisfies the debt. Credit bureaus report credit accounts closed for nonpayment as "charge offs," another negative credit event that hurts credit. After a charge-off, creditors often assign the accounts to debt collectors and list them on credit reports as "collection accounts." Settling debts does not remove charge-offs or collections information but shows creditors that the debtor eventually resolved the account through settlement. That is important because some lenders, such as mortgage companies, will not extend credit to a debtor if the credit report shows active collection accounts. That makes paying off balances though settlement a good move even if there is initial harm to credit reports.