Why Debt Settlement Hurts Your Credit Score

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There are times when your debt may seem like too much to handle. Making the payments can seem impossible — especially if you’re trying to choose between groceries and credit card debt.

When you feel overwhelmed, one option is debt settlement. But while debt settlement can be a solution, it’s important to understand that there are some drawbacks, including harm to your credit score.

"A lot of people have misconceptions, thinking they’ll be off the hook," said Beverly Harzog, a credit card expert and consumer finance analyst for U.S. News & World Report. "It’s important to go in with eyes wide open."

Before you decide to pursue debt settlement, here’s what you need to know.

What is debt settlement?

Debt settlement is a method of debt relief in which a creditor agrees to accept less than you owe on an obligation. You work with the creditor, on your own or through a company you hire, to either figure out a payment plan or pay a lump sum, whichever you can afford. That then allows the creditor to recoup at least some of what they are owed.

In many cases, said Harzog, creditors are happy to get anything from you, so you might be successful in negotiating a lump sum or setting up a payment plan — either of which results in you paying less than the full balance.

You do have to be careful, however. If a lender agrees to settle your debt for less than you owe, some portion of the forgiven amount might be considered taxable income by the IRS. If your settlement includes more than $600 in reduced principal, you should receive a 1099-C from your creditor — and that amount will be considered income by the government. In general, explained Harzog, you shouldn’t expect to pay taxes on interest and late fees that are part of the settled debt.

So, if you owe $10,000 and the creditor agrees to accept $6,000, your debt is reduced by $4,000. If $2,000 of that is principal, that amount will count as income and you will pay taxes on it.

There are some exceptions to this rule, however. "If your debt exceeds the value of your assets, you might not owe taxes," Harzog explained.

How debt settlement affects your credit

While debt settlement can seem like a great idea to reduce the amount you repay, it’s important to understand the consequences — especially if you’re struggling to make payments but have not yet started missing them. Many creditors won’t agree to settle debt if it’s not seriously delinquent.

For that reason, a debt settlement company usually advises you to stop paying your debts.

"This can really trash your credit score in a big way," said Harzog.

Payment history is the biggest factor in your FICO credit score, accounting for about 35% of the calculation. Once you start missing payments, that makes a tremendous difference. The higher your credit score, the bigger the impact is likely to be.

"If you have a high FICO score, one late payment on your credit report could make your score drop around 100 points," says Harzog. "The higher the score, the bigger the drop."

When you enter debt settlement and keep missing payments, the impact can really add up. Harzog pointed out that it can take up to two years for many settlement programs to make headway, and you’re piling up delinquent accounts in the meantime.

On top of that, said Harzog, a notation that an account has been sent to collections can also show up on your credit report and impact your overall creditworthiness in the eyes of financial services companies.

Additionally, as Todd Christensen, a financial counselor with debt education website MoneyFit.org by DRS, pointed out, the way the creditor reports the settlement can make a difference. "By paying less than the full balance, the borrower has not paid as agreed according to the original loan or credit card terms," Christensen said. "That notation can negatively affect your score."

Settled accounts and missed payments can remain on your credit report for up to seven years. While the impact fades with time, the fact that they are visible still has an effect.

What happens if you quit the debt settlement program?

As you might expect, quitting a debt settlement program will set your credit score back. This is still a credit repayment agreement, so ending your involvement without fulfilling your end of the deal is likely to lower your credit score.

Harzog also pointed out that after you’ve been in a program for two or three years, your credit score starts to improve by quite a bit. As you move further out from the original missed payments and as you enter payment agreements, the better, more recent information starts to overcome the old designations and help you rebuild your score.

However, quitting a debt settlement program can erase all of the progress you made after the initial hit to your score. Your debt will show up on your credit report as unpaid if you fail to complete your program.

"Before you enter, make sure you can actually complete the program," Harzog said. "Some programs last five or six years, so make sure you can stick with it."

How to settle your debt

While a debt settlement company can work on your behalf and take care of most of the leg work, it can be expensive. Christensen said some companies add a fee of between 15% to 25% to your debt settlement.

It’s also possible to settle the debt on your own. Here are some basic tips for working with creditors when attempting your own debt settlement:

  • Call the creditor and ask for a debt settlement. It’s also possible to negotiate via email or mail, if you want to minimize the emotional aspects of the negotiation.
  • Be direct and honest about your situation.
  • Know what you can afford before you call.
  • Offer them something. They are more likely to agree if you can name a lump sum or let them know what you can afford each month.
  • Get the terms of the agreement in writing, either by email or snail mail, before you agree to let them take anything from your checking account.

If you have a temporary situation, you might be able to avoid debt settlement altogether by calling your creditor’s customer service line and asking for the hardship department.

Most creditors actually have programs aimed at helping those with short-term job loss or some other financial issue. If you call and speak with someone, you might be able to receive forbearance or a lower payment for up to 12 months.

Beware debt settlement scams

Unfortunately, where there are desperate people, there are scammers ready to prey on them. Debt settlement can make sense in some situations, but if you decide to work with a debt settlement company, it’s vital to be on the alert for red flags.

Watch for these warning signs to avoid getting taken in by a scam:

  • Promises about an exact amount they can settle for (e.g., claiming they’ll wipe out 100% of your debt)
  • Requests for money upfront
  • Numerous complaints with the Better Business Bureau and other places online

"You have to be very, very careful with debt settlement companies," said Harzog. "Just doing your research is going to help you feel better walking into it."

Is debt settlement worth it?

Whether debt settlement is worth it for you depends on your situation, and where you are with your debt.

"Debt settlement is best for people who are already having trouble with missed payments," said Harzog. "If your credit score is already shot, debt settlement can be a way out without resorting to bankruptcy."

Before making your decision, it’s important to understand the advantages and disadvantages of debt settlement.


  • A plan to become debt-free
  • Reduction in the total amount you pay
  • Manageable payments that fit your budget


  • Might owe taxes on part of the settled debt
  • Potentially large drop in your credit score
  • Can take two years or more to recover your credit score
  • No guarantee it will work, and the potential that creditors may decide to sue you instead

Perhaps the biggest risk to debt settlement is that you could enter a program and the creditors might refuse to work with the company.

"Be aware that you are highly likely to be sued by the creditor if they feel that obtaining a judgment in court and pursuing wage garnishment is worth their time and effort," said Christensen, adding that "the lender might end up selling the unpaid balance to a collection agency that will re-commence collection activities."

Remember, there are other ways to get out of debt that you can explore to find the best solution for your situation.

The bottom line

If you haven’t started missing payments, and your credit score hasn’t been affected in a big way, you might be able to use debt consolidation to help you manage your debts, said Harzog.

Additionally, she recommends reaching out to the National Foundation for Credit Counseling to find accredited local counselors who can work with you. Talking to a credit counselor in your area can help you get into a debt management plan. It might come with fees, and you end up paying what you owe in full, but it will not impact your credit score.

While your credit is important, Harzog said the real priority at this point is to work on getting out of debt. "Don’t focus on your credit score right now," Harzog said. "Focus on paying off the debt and moving forward."

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