Settling your debt can have a significant, negative effect on your credit.
How much your credit scores are impacted by student loan settlement depends on a variety of factors like:
- if you already have good credit,
- whether your other debts are in good standing, and
- how much less you pay than the original balance
It’s always better to pay the full balance of your debts. Paying off a debt will appear as “paid in full” on your credit. This shows lenders that you fulfilled your obligation, and they’re likely to get their money back as well.
However, you may not be able to pay the full amount — most people can’t. That’s where debt settlement comes in.
Is debt settlement really worth it? Debt settlement can be worth it, depending on your financial situation. If you have the lump sum available to pay off a settled debt, negotiating a debt settlement is usually worth it because:
- You can begin the long process of credit score recovery sooner, rather than later.
- You will pay less in the long run.
- You will experience less stress.
Disclaimer: This post contains general information as well as affiliate links. If you would like personalized student loan legal advice, schedule a free 10-minute call with me.
5 debt settlements that can damage credit scores
Your credit score is made up of several factors, each of which is weighted differently for credit reporting. The most substantial credit score factors are your payment history and credit utilization. Other items that determine your credit score are the length of your credit history, new lines of credit, and your credit mix.
Debts tied to an asset like a car loan or a mortgage have different settlement procedures and credit impacts from unsecured debts like credit cards and personal loans. Student loans have a range of settlement options depending on the type of loan, but settling will damage your credit regardless.
This makes each debt a little different in terms of settling.
Is it better to settle a debt or pay in full? It’s better for your credit score to pay a debt in full, but better for your wallet to settle a debt for less than you owe if you don’t have the money to pay. Ultimately, you have to decide if you can afford the cost to your personal finances versus the cost to your credit.
Keep in mind, missed loan payments have already damaged your credit score. If you’ve defaulted on a student loan (or have multiple lapsed payments on other loan types), settling can actually give you the relief to start rebuilding your credit.
Here are the 5 most common debts that can be settled, as well as how much they can damage your credit score if settled:
- Student loan debt
- Credit card debt
- Auto loan
- Personal loan
1. Student loan debt
Can debt settlement hurt your credit score? Yes, settling student loan debt for less than you owe will hurt your credit score.
Your payment history reflects the status of each loan on your credit report. When you settle, this status shows that you settled for less than you owed, which creditors don’t want to see. However, that hit is less impactful than a history of missed payments.
This is important to keep in mind if you are considering a strategic default in hopes of settling. Be aware that your credit will take a significant hit from the defaulted status and the settlement, making it harder to get other types of loans in the future and raising potential interest rates.
Many people have questions about “pay for delete” arrangements when it comes to removing a settled debt or missed payment from your credit report. This doesn’t happen for student loans, and many experts believe it’s becoming outdated overall.
Here’s the bottom line: If you have the option to continue timely payments on your student loans, that’s probably the best choice. It’s very unlikely you will reach a settlement that offsets the costs of defaulting and credit damage.
If you’re already in default, settlement may be a good option, especially on private student loans. (Rehabilitation can be another good option for federal loans; more on that later in this article.)
2. Credit card debt
Settling a credit card account can relieve you from expensive interest and take a sizable chunk out of your outstanding credit card balance. However, settling that debt can drastically affect your credit.
The damage to your credit score from a settled debt is due to two factors:
- Your credit score will indicate you settled for less than you owed, which lenders don’t like to see.
- The card will have been closed in order to settle. A closed account can affect your credit score by reducing the length of your credit history.
If settling with your credit card issuer isn’t an option, consider a balance transfer or debt consolidation loan if you can get it. You’ll start fresh with a new, single loan with one monthly payment and a (likely) lower interest rate.
3. Auto loan
Auto loan lenders tend to repossess a car if your auto loan goes bad. However, repossession is costly for the lender, and they aren’t likely to recoup the total amount of the loan in resale.
This leaves room for you to negotiate settlement offers. While your credit will take a hit by settling, the damage might be a lot less compared to the loss of your car as well as a hit on your credit due to repossession.
4. Personal loan
You can often settle personal loans for 50% or less of the remaining loan amount, depending on the lender.
In this case, timing is everything. The closer a lender is to selling your debt to a collection agency or charging it off completely, the more likely you will get a good deal.
Here’s why: If the lender “charges off” the debt, they close the account without getting anything. A charge-off is a credit score killer, even more than a settlement. If you offer to settle for even half, they’ll probably accept since it’s better than nothing.
Unfortunately, paying a loan just before it’s charged off also means racking up missed payments. Like with student loans, the missed payments may cost you more in the long run than continuing to pay back your debt.
Like auto loans, a mortgage is tied to a physical asset: a house. Homeowners that do not pay their mortgages often end up foreclosing. But like repossessing a car, foreclosure is costly for your lender.
On the other hand, a mortgage is the most valuable credit line you can have on your credit report. As a result, a foreclosure is the most costly derogatory mark.
If you can negotiate a mortgage settlement with your lender — which is very difficult to do — you’ll probably avoid a much bigger hit to your credit than if you foreclosed.
How does debt settlement work?
Debt settlement allows you to resolve the balance on any debt for less than the total balance owed. If your lender is willing to negotiate a settlement, you will pay a lump sum of less than the total balance you owe, and the lender considers that debt no longer due.
Most loans allow for a settlement after consistent nonpayment. However, my specialty is with student loans, so I’ll use those as an example here.
Here are the basic steps to negotiating a debt settlement.
1. Determine how much you owe on delinquent and defaulted loans
First, you’ll need to find out what kinds of student loans you have and who currently holds those loans. You can get that information through the studentaid.gov database or by getting a copy of your credit report.
You can’t settle a student loan that’s in good standing. Identify which loans are in delinquency or in default to find the candidates for a potential settlement.
2. Contact the collection agency to negotiate a settlement
Next, contact the servicer or collection agency that currently holds your loans. Let them know — politely — that you would like to settle your student loan.
Then, negotiate a settlement amount that you can realistically pay right now in a lump sum. If the lender accepts, get the settlement agreement in writing.
3. Pay your settlement amount
Finally, pay the settlement amount within the specified timeframe. Make sure you receive written confirmation that the student loan has been satisfied.
Your student loan balance will be brought to zero, and your credit report will be updated around 30 days after they’ve processed your payment. Your credit report will show a zero balance for the loan, and the status will indicate you settled for less than what you owed.
What is the minimum payment to settle debts? The minimum payment to settle a debt depends on the lender. Federal student loan debt settlement programs won’t settle for less than 85% of the outstanding balance. Private student loans may settle for 40-70% of the debt owed.
For credit cards, mortgages, auto loans, and personal loans, you’ll need to contact your loan servicer to determine a settlement amount they’ll agree to. Since most of these lenders are private, the minimum payment to settle these debts can vary.
Settling student loan debt to improve credit
What are the benefits of debt settlement? Settling your debt will have a negative impact on your credit in the short term. However, debt relief stops future damage by preventing future late payments and late fees and preventing the debt from going into collections or being charged off.
The last thing you want to do is ignore it and hope it goes away. A charge-off on your credit report has an even bigger impact on your credit than a settlement does.
Plus, for federal student loans, defaulted accounts never truly go away. Instead, the government will take your tax refunds, wages, and other measures to regain their losses on your loan.
If coming up with a lump-sum payment is impossible for you, you may have another option that will actually improve your credit right away: student loan rehab.
Student loan rehabilitation to improve credit
Student loan rehabilitation is an excellent way for you to reverse the damage of a defaulted student loan. The only limitations are the loan must be in default, it must be your first time defaulting, and the debt has to be a federal student loan.
Also, won’t get close the account, which would further harm your credit. Rehabilitation is designed to get your loan back on track, which can boost your damaged credit history.
Student loan rehabilitation requires you to make 9 on-time payments within a 10-month period. You can work with the lender on your monthly payment amount and can usually get extremely low payment amounts.
Once completed, the “default” status will be dropped from your credit report, and the loan will show as current. The late payments that got you into default will remain, but your credit score will get a little boost.
Afterwards, you’ll need to re-enter a new repayment. Whatever it takes, do not fall behind again — student loan rehabilitation is only available once. Make sure you continue to make your payments on time once you’re out of default.
How does a student loan settlement impact my FICO score?
A student loan settlement negatively impacts your FICO score because future lenders won’t want to lend you money if the last lender didn’t get all of it back.
A credit score, such as your FICO score, is a representation of how likely you are to repay your debts. Creditors use your credit score to decide whether to approve you for a loan.
How much does debt settlement affect your credit score? You can expect your credit score to drop about 100 points as a result of debt settlement. However, everyone’s credit situation is different, and the credit bureaus’ credit scoring models are still somewhat of a mystery.
How a settlement affects your credit
A settlement affects your credit score in multiple ways, regardless of the type of debt.
The 3 ways settling a debt can hurt your credit are:
- The missed payments leading up to a debt settlement will ding your credit. Since 30% of your score depends on just your payment history, it’s safe to say most of the damage is already done.
- When you contact your lender and let them know you’d like to settle, they’ll likely close your account right then or shortly after. This will further lower your score by increasing your credit utilization rate and decreasing your credit age.
- When you pay off the total balance of a debt, the lender updates your credit report to show a status of “paid as agreed” or “paid in full.” If you can’t pay the full amount, they’ll mark it with another status like “settled,” “paid settled,” or "unpaid" that will drop your score.
How to help your credit recover
Late payments and settled accounts will stay on your credit report for 7 years. The effects of these derogatory marks will ease over time, but there are measures you can take as you wait.
Here are 3 ways to help your credit recover faster:
- Continue making on-time payments on all debts in your name.
- Pay down any credit card balances you have.
- If you don’t have credit cards, consider getting a credit-builder or secured credit card.
How long does it take to improve credit score after debt settlement? It could take 12-24 months after debt settlement to improve your credit score. After a settlement, you will have some work to do to rebuild the payment history portion of your credit report.
Negotiating with debt collectors can be tricky. Seeking help from a debt settlement company or credit counselor can help you work out a solid debt management plan. If you’re struggling with student loan debt, there’s help available.
Your best option? Take action.
The bottom line: If you’re struggling with your student loans or are already in a mess, I want to talk with you. I’ve helped hundreds of people negotiate settlements, get out of default, and stop wage garnishments and IRS offsets.
Schedule a free 10-minute call with me today. We can go over your options together and help you begin picking up the pieces.