Will a Debt Settlement Damage My Credit?

Debt settlements can be a viable option for people who are deeply in debt and want to avoid bankruptcy. Still, debt settlements do have a negative impact on credit ratings. The amount of damage caused by a settlement depends on a person's credit history. For instance, someone who previously had a good credit rating will likely see a bigger drop in his credit score by not paying his accounts in full through debt settlements than someone who has a poor credit history.

Function

Debt settlements usually allow people to make a one-time payment to creditors for an agreed upon amount that is less than what's owed. A creditor may agree to settle an account for as little as 20 percent of the total balance. The account holders get some debt relief, but credit reports usually note when debts are settled for less than the full amount owed. Such notations will be viewed negatively by future creditors. Any delinquent account payments that preceded a settlement also will remain on a person's credit report even though the account has been closed.

Considerations

Debt settlements also can affect people's tax liability, making their credit and debt problems worse. Debts that creditors forgive in excess of $600 are considered taxable income. As a result, someone who is already struggling to pay debts could end up deeper in debt by having to pay more in taxes due to settlements with creditors.

Effects

Creditors usually have to stop efforts to collect debts if a person files for bankruptcy. Debt-settlement efforts don't have the same effect. Creditors can continue trying to collect debts even if their customers are seeking settlements. They also may turn an account over to a collection agency in the midst of a customer's settlement attempts. Collection accounts that appear on credit reports cause credit scores to drop.

Warning

People can unwittingly damage their credit if they choose to work with a debt-settlement company instead of trying to settle their debts themselves. Some companies advise their clients to stop making payments to their creditors and to send the payments to them instead. The companies promise to hold the funds in an account until enough money is accumulated to offer a settlement to the clients' creditors. However, creditors will add late fees to the clients' accounts for every payment not received. Payments that are more than 30 days late will appear on credit reports and lower consumers' credit scores.

Prevention

Working out a debt-management plan with a local credit-counseling agency is an alternative to seeking debt settlements. A person who has a debt-management plan agrees to make monthly payments to a credit-counseling agency that uses the money to pay that person's bills. Such agencies work with creditors to lower a client's interest rates, eliminate penalty fees and stop collection efforts. Consumers who fail to complete debt-management plans typically aren't worse off than when they started. Failure to complete an arrangement with a debt-settlement company can damage a person's credit if late payments and collection accounts have grown.