Does Settlement Debt Hurt a Credit Report?

For an individual with overwhelming debts, successfully negotiating a debt settlement with a creditor brings about a sense of relief --- but that relief may be short-lived. Debt settlement, or the act of satisfying your full account balance by paying only a portion of the debt, has an adverse impact on your credit scores. In addition, creditors still consider the newly modified debt, or "settlement debt," when determining your total debt liability.

Settling Hurts Scores

For the FICO credit scoring system, recent accounts are the most relevant when determining a consumer's credit scores. Fortunately, making a payment on an old debt does not make the account appear more recent and thus drop your credit rating. When you settle an account, however, the creditor adds a new feature to its trade line on your report noting that the debt was settled. Unlike making payments, settling a debt causes the account to update as more recent within your credit history. Because settling a debt for less than you owe is considered derogatory in the credit scoring system, your credit score will drop as soon as you settle the account.

Collection Agency Settlements

Settling with a collection agency differs considerably from settling accounts with the original creditor. Because the exact formula the credit bureaus and the Fair Isaac Corporation use for calculating credit scores is a trade secret and neither company has released information regarding collection agency settlements, there is no way to know ahead of time how settling collection debt will impact your credit scores. Liz Pulliam Weston of MSN Money refers to collection settlements as a "wild card." Settling these accounts could either positively or negatively impact your credit, depending on the other information present within your report.

Credit Reviews

When lenders review your credit report, they look not only for evidence of past nonpayment but at your total debt load. The amount you owe other creditors helps new lenders determine whether or not you can afford to make payments on a new account.

If you pay off your debt settlement through periodic payments rather than in one lump sum, any future lenders reviewing your report take your settlement debt into consideration when evaluating your creditworthiness. In addition, the fact that you were unable to pay the amount you originally agreed to with your previous creditor counts against you in the eyes of future lenders.

Is It Necessary?

Settling a debt eliminates your liability to your creditor, but it may not be necessary. If the statute of limitations in your state has expired, your creditor cannot force you to pay off the debt through a lawsuit. On the same note, if the federal reporting period on the debt has also expired, the credit bureaus can no longer list the debt on your credit report --- even if it is passed from collection agency to collection agency.

If you have a moral obligation to pay off your debts, then working to satisfy your obligations is a must. From a financial standpoint, however, if a creditor cannot force you to pay the debt and the account no longer appears on your credit history, negotiating a new settlement debt and paying it off does you little good and is not strictly necessary.