People struggling to stay current on obligations often ask how a debt settlement program affects their credit report and score. The effects are bad at first and good over the long-term.
Cons – A debt relief program will always hurt your credit score in the beginning. However, this should not matter to the borrowers who meet the financial hardship criteria. Their rating is already at the bottom.
Pros – A successful debt reduction program often helps your credit score recover more quickly over time – after it takes the initial meaningless hit. This is especially true when compared to the alternatives. A public record item could appear and then remain on your consumer report for another 7 to 10 years.
When Debt Settlement Programs Hurt Credit Scores
Debt settlement programs will always impact credit scores adversely in the beginning. The process results in two sets of negative payment history information on your consumer report, during the monthly payment stage, and after a successful negotiation. Both suppress your risk rating temporarily. However, this dip is meaningless for most qualifying participants.
Do you qualify for debt relief? Financial hardship is the primary eligibility criteria. Financial hardship occurs to people with lost income due to unemployment and disability, or to people with a sudden surge in expenses – often connected with a medical event. You must owe more than $10,000 in unsecured obligations such as unpaid credit card balances, personal loans, and medical bills.
Monthly Payment Stage
First, debt relief programs temporarily hurt your credit score during the monthly payment stage. During the monthly payment stage, you divert all of your resources into building a settlement fund in an escrow account held by a third party bank. In other words, you stop making payments on all of your unsecured borrowing accounts.
Your creditors will pass along this negative history to each of the three consumer bureaus. However, this does not matter to borrowers suffering a true financial hardship but does to those who are not.
People suffering financial hardship are already late by several months on multiple obligations.
- Being later on more obligations may further suppress your credit score – but that should not matter. Your rating is already too low to qualify for any new loans.
- The negative payment history disappears from your file 7 years after the date of first delinquency. The clock has already started ticking. Therefore, you have less than 7 years remaining.
If you are current on all of your obligations, a debt consolidation loan, or a counseling service are better alternatives.
- You are not experiencing a financial hardship if you can make all of your payments on time. There is no reason for your lenders to agree to accept less than full payment.
- Diverting funds into an escrow account establishes a negative history, which damages a relatively good score for at least 7 years. The clock has just begun ticking. You do not want to suffer these consequences.
A successful debt negotiation results in the lender and/or collection agency communicating a “paid settled” status to the consumer bureaus. This negative item will appear on your consumer report and will hurt your credit score until it ages from your file.
However, “hurt” is a relative term. You have to compare the severity of the two alternatives. A “paid settled” status is harmful to your credit score, but continuing to leave the account open and unpaid does far more damage.
- “Paid settled” is less severe because the lender agreed to accept something less than 100% of what you owe. It is paid, and you no longer owe the money.
- Older negative items count less than open bad marks. As time passes, the impact of the final status diminishes.
- “Now delinquent by X number of days” is more severe, because the lender has not agreed to these payment terms. The same holds true for a “charge off.” You still owe the money.
When Debt Settlement Programs Help Credit Scores
Debt settlement programs will often affect your credit score positively and help it recover over time, and can shorten the time it takes to happen. The amount of time needed will vary for each individual situation. Two different factors often come into play.
- You reduce the amount of money they owe.
- You avoid public records, which have nasty long-term consequences.
Debt reduction services improve credit scores immediately after the lenders sign off on the settlement letter. Your consumer report should now show that you owe far less money than before. The lenders and/or collection agencies will communicate the “paid settled” status noted above. They will also update the outstanding balance from a large amount down to zero.
The amount owed makes up 30% of the average consumer’s credit score. The equation often calculates two different ratios to make its prediction.
- Revolving utilization ratio – divides the revolving balances by the cumulative limits. A ratio below 30% is good. Since you had probably maxed out most of your newly closed credit card accounts, this ratio looks better.
- Total utilization ratio – divides the outstanding balance by the initial principal (installment contracts) or account limit (revolving accounts). This percentage should also look better.
Your debt-to-income ratio should also recover, as the expected monthly payments suddenly drop to zero from a much higher figure. This improves your overall qualifications, although your credit score does not consider income.
Avoid Public Records
Debt relief programs can help your credit score by avoiding the appearance of public record items on your consumer report. A public record can appear after a county court files a judgment or bankruptcy. They hurt your ratings in two different ways; they represent a second major derogatory item, and they can remain on your file much longer.
Major Derogatory Item
Debt reduction services can help your credit score by preventing a second major derogatory item from appearing on your file. A public record is much worse than a “paid settled” status because the legal system got involved. You can avoid having this additional negative mark appear on your consumer report by settling your debt before the lawyers take up your case.
- With a judgment, the lender sues in court in order to compel payment of an outstanding obligation. A judgment confirms that you owe the money, failed to pay on time and that the court believes you have the means to repay what you owe.
- With a bankruptcy, the court agrees to either restructure or absolve your obligations because of financial hardship. The court forces the lender to accept less than what you owe.
Stop from Appearing
Debt relief programs can help your credit score recover more quickly when you prevent public records from appearing in your file. If the situation remains unresolved, they can pop up anytime, and haunt you for another seven to ten years – counting from the filing date.
This is what makes them such a powerful alternative to bankruptcy.
Pop Up Anytime
Public record items can pop up onto your consumer report at any time – up until the statute of limitations in your state. The statute of limitations laws in your state time bars lenders rights to file suit in order to collect a debt. The range is three to six years for revolving balances (credit card), and three to fifteen years for installment contracts.
Until the statute of limitations expires, the lender can file a lawsuit. If they win the lawsuit, the court will file a public record, which the bureaus collect and post to your consumer report. This means new negative information can appear on your file years after you first fell behind on payments.
Haunt another 7 to 10 Years
Public records can haunt your consumer report for another seven to ten years. They age from your file based on the court filing date, rather than the date of first delinquency.
- Judgments – 7 years
- Bankruptcy Chapter 13 – 7 years
- Bankruptcy Chapter 7 – 10 years
In summary, a successful debt settlement program affects your credit report and score in a meaningless way at first. However, after the lender agrees to accept the lesser amount, the process has a very positive impact on your ratings. Your amounts owed are much better, and you avoid the long-term nasty consequences of public record filings by the county court.