Thursday, March 9, 2017

What Happens To Your Credit Score When You Settle A Debt?

We’ve got a guest contribution for you today about debt settlements. Obviously, our preference would be that you never ever ever find yourself in a situation where you are considering debt consolidations. We would much rather see you winning with your finances and not have to worry about this. But reality isn’t always pretty, and if there is no way for you to clean up your credit mess the more ethical way (ie. paying it back in full), then debt settlement is an option. It might not be something I agree with but I wanted to add this information here so that you will be fully aware of the implications in case you find yourself exploring this option.  Over to Stacy …


Many debtors are tempted to settle debts since they have to pay less than what they owe. But, they are not sure about its effect on credit score. Perhaps this is why if you check out any credit card debt settlement forum, you’ll find that it’s filled with questions like “what is your credit score after settlement?”, “how does debt settlement affect credit score”, “can debt settlement boost up my credit score?”

I have participated in various debt and credit forums in the last 7 years and there isn’t a single day when someone has not asked this question. And, my answer to all these questions is always the same - debt settlement hurts your credit score.

How does debt settlement affect credit score?

Debt settlement sounds like a dream come true when you don’t have enough cash to pay off debt. You make a big one-time payment to the creditor in exchange for having the remaining debt forgiven.

Let me explain this with a simple example.

Let’s say your total credit card debt amount is $9,000 and you haven’t made the minimum payment for several months. You can contact the settlement company, and negotiate to bring down the payoff amount to $4,500. If the creditor agrees, then you pay $4,500 on the stipulated date, and the remaining amount ($4,500) is forgiven.

Remember, the creditor is not bound to reduce your payoff amount. The amount is always negotiable, and the creditor is less likely to settle your credit cards when you’re current on your payments.

Now, comes the most important question - How does debt negotiation affect your credit score? Why does debt settlement pull your credit score down?

Give me a few minutes to clear up your confusion.

Referring to the aforementioned example. How much did you save through debt negotiation? It’s $4,500. How much did you borrow in total? It’s $9,000. This means you paid only half the amount. This means you enjoyed $9,000 and paid back only $4,500 to the lender. Is this a good consumer behavior? FICO doesn’t think so. Hence, your credit score drops.

Rod Griffin, the Director of Public Education, Experian, says,

“When you settle your debt, the activity usually shows up on your credit report as ‘debt settled’ or ‘partial payment’ or ‘paid in settlement”

This account status remains on your credit report for 7 years and 180 days. The negative effect on your credit score gradually goes away with the passage of time.

You can talk to your creditor about the specific language he uses. But the main point is: this is a red flag on your credit report.

How much your credit score can drop?

FICO hasn’t officially declared how much your credit score can drop after settling debts. But the higher your credit score is, the bigger the drop will be. If your credit score is already low due to late payments or missed payments, then settling debts will have little negative effect on your credit score.

In 2009, FICO released an information regarding debt settlement’s effect on credit score based on 2 hypothetical consumers with separate credit scores.

First scenario

Consumer’s credit score is 680 and he has made only one late payment.

Effect of debt settlement: Credit score would drop between 45 and 65 points.

Second scenario

Consumer’s credit score is 780 and is not delinquent on other debts.

Effect of debt settlement: Credit score would drop between 140 and 160 points.

You may see a similar drop in your credit score if your credit profile is similar to the aforementioned scenarios. You’ll also see a bigger drop in your credit score when you settle multiple credit cards.

Why should you still settle debts?

It is true that settling a debt is not good for your credit score. But, this is still better than ignoring the debt completely. Your credit score will drop initially and you’ll get lots of chances to improve it. But your credit score will drop even more if the debt is not paid off. Creditors may file a lawsuit against you to garnish your wages or impose a lien on your property. You’ll eventually find yourself in an even bigger problem.

First, you’ll face problems in getting a loan from lenders. Prospective lenders will consider you as a risky borrower. In this situation, several things can happen:

-       Lenders would reject your loan application
-       Lenders would charge a very high interest on your loan
-       Your employer will deduct a portion of your paycheck till the debt is satisfied
-       If you sell any property, then the sale proceeds will be used to pay off judgment

The only way to get out of this problem is to settle debt after judgment.

Conclusion

Debt settlement helps you get out of debt, particularly when you can’t pay the full balance. This may mean that you have to sacrifice your credit score temporarily. But once you have settled your credit card debts, you can start rebuilding your credit. Timely payments and responsible borrowing can help you achieve your goal.



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