Debt settlement can help you pay off unsecured debt, like credit cards, for less than you owe, offering a way out of overwhelming, high-interest debt.
But debt settlement has risks, including a hit to your credit score. Learn how debt settlement works, how it affects your credit and what alternatives to consider.
How does debt settlement work?
Debt settlement is the process of settling your debt for less than you owe, usually with the help of a third party, like a debt settlement company.
Debt settlement companies typically advise you to stop making payments on your debts and instead put that money into a separate escrow account. As your debt becomes increasingly delinquent, your creditor may be more likely to accept a settlement offer versus the risk of you not paying at all. If your creditor accepts the offer, the settlement company uses the money in the escrow account to settle your debt.
How does debt settlement affect your credit?
Debt settlement can negatively impact your credit in a few ways.
Missed payments: As you stop paying your debts, your creditors will report these late payments to the credit bureaus after 30 days. Payment history makes up the largest part of your credit score, so any late or missed payments will hurt your score.
Overall debt may increase: As interest accrues on your credit cards, your credit utilization ratio will increase. This ratio measures how much available credit you’re using, and it’s an important factor in calculating your credit score. Typically, the more debt you have in relation to your available credit, the worse your credit score.
Collections activity: As your account becomes increasingly overdue, your debt may be turned over to in-house or third-party collections. This debt will be marked as a collections account on your credit report, which can lower your credit score even more, though it may vary based on how much your credit score has already been affected.
Settled accounts are reflected on credit report: Settled accounts show you weren’t able to fully pay back what you owed, which is seen as a negative by future creditors. Settled accounts can stay on your credit report for seven years.
Can debt settlement ever help your credit?
Debt settlement is likely a better choice than not addressing your debt at all. From that perspective, settlement may be better for your credit than sinking further and further into debt, with no plan of getting out. These aren’t your only two options, though, and it’s smart to explore debt relief alternatives besides settlement.
Alternatives to debt settlement
Consider other ways to address your debt before moving forward with a debt settlement company.
Debt management plan
A debt management plan combines your credit cards into a single payment with lower interest, which makes them easier to pay off. These plans are offered by nonprofit credit counseling agencies and can help you get out of debt in three to five years. Though you may see an initial hit to your credit score when you enroll in a debt management plan, your credit will likely improve after completing the plan.
Debt consolidation loan
Debt consolidation loans are personal loans that combine multiple debts into one — ideally at a lower interest rate — and make them easier to pay off, similar to a debt management plan. You can apply for this type of loan at your local credit union or with an online lender, even if you have bad credit.
Applying for a debt consolidation loan requires a hard credit pull, which temporarily knocks a few points off your score. As long as you make your loan payments on time, you can use a debt consolidation loan to help build your credit score.
Bankruptcy
If your debt accounts for more than 40% of your income, and it’ll take five years or more to pay off, bankruptcy may be an option. Filing for Chapter 7 bankruptcy can wipe out unsecured debts, but similar to debt settlement, it has a significant impact on your credit score. However, you may see a faster rebound in your score with bankruptcy versus debt settlement. A credit counselor can help you decide if bankruptcy is the right fit.
