Will Paying a Settlement Rather Than the Total Balance on a Credit Card Hurt Your Credit Report?

You've probably heard the expression---you can't have your cake and eat it, too. You can apply the same thinking to settling your credit card debt. You can certainly save money if you settle, but you won't keep your credit report golden if you do.

Definition

Debt settlement is negotiating with your creditor to pay less than what you owe. You can negotiate yourself or you can hire a debt-settlement firm to negotiate for you. If you hire a debt-settlement company, be aware that many such firms are fraudulent. Some charge upfront fees and then disappear with your money, according to MSN Money. If that happens, you lost money that you probably couldn't afford to lose. This could eventually affect your credit score, if the loss makes it difficult for you to pay your bills.

Significance

The good news is that debt settlement is a legal way for consumers who cannot pay their debts to avoid bankruptcy. The bad news is that the credit-card companies will report to the credit bureaus that you settled, which hurts your credit score.

Function

Typically, in order to get a credit-card company to settle with you for less than what you owe, you need to be delinquent on your payments. Otherwise, the credit-card company will have no incentive to settle with you. You generally have to be three to six months behind before a creditor will negotiate, says Gerri Detweiler, author of "The Ultimate Credit Handbook," on the SmartMoney website. Once you become delinquent, your credit score will nose-dive. Payment history accounts for 35 percent of your FICO score.

Considerations

If your credit is already shot, then debt settlement won't make your credit much worse. On the other hand, if you have good credit and have avoided delinquencies and charge-offs in the past, debt settlement will hurt your credit. MSN Money illustrates just how this works. FICO scores range from 300 to 850. If your score is 680, for example, and you choose debt settlement, your score will drop 45 to 65 points. If your score is 780, your score with a debt settlement on your record will drop 105 to 125 points. These scores assume you only missed one payment. In reality, with debt settlement, you probably will miss more than one payment, with each missed payment further lowering your score.

Expert Insight

Debt settlement could save you money, but it may not be as much as you think. If you do settle your debt, the amount that your creditor forgave you in the settlement becomes taxable income. In addition, if you use a debt settlement firm, the fees are usually high. Some companies charge 14 to 18 percent of the debt you want settled, according to MSN Money.