How Does Settling a Debt in Collections Affect Your Credit?

The ghosts (or zombies) of your unpaid debts almost always come back to haunt you, usually in the form of annoying phone calls, incessant letters, and confusing settlement offers. Once your outstanding debt is sold to a collections agency, those agents will do their best to convince you to settle your old debt with them.

A Few Words of Caution

If you do decide to work with a collector, first and foremost, you want to make sure they’re a legitimate company. There are a lot of scams out there, and if the collector is harassing you or demanding immediate payment, or they don’t accept common forms of payment, those are red flags. Also, thanks to the Fair Debt Collection Practices Act, collectors are required to send you a written notice of your debt within five days of initial contact. This is also called a debt validation letter, and most reputable collections agencies will send this before contacting you by phone.

Before you agree to anything, you also want to fully understand what you’re getting into. Many people jump into debt settlement because it seems like an easy fix. Debt settlement is tricky, though, and it may not repair your credit as much as you’d think. To be clear, for the remainder of the article, we’ll be discussing debt settlement with a collection agency, which is different from working with a debt settlement company.

What Happens When You Settle Your Debt

Paying off your debt, even some of your debt, seems like the responsible thing to do. However, credit scoring companies don’t necessarily see it that way. When you stop making payments on a debt, the original creditor sells it to a debt collector, and, as you can imagine, this negatively affects your credit.

“When you settle a debt you negotiate repayment for less than you actually owe,” says Rod Griffin, Director of Public Education for Experian. “Once a debt has been sold or transferred to collection, any payments or negotiation should be done with the collection agency. They are now the legal owner of the debt. The original account should have a status of charge off and will indicate that it has been transferred or sold to collection.”

Settling a debt is considered negative activity, but Griffin points out that it’s still better than not paying at all. “Your credit scores will suffer anytime you settle a debt and will decline even more if you don’t pay at all,” says Griffin.

When you settle your debt, the activity usually shows up on your credit report as “debt settled” or “partial payment” or “paid in settlement.” You can talk to the settlement company about the specific language they use, but the bottom line is: this is a red flag on your report. FICO doesn’t reveal how much your score will drop, exactly, and your report doesn’t indicate how much of the original debt was forgiven; it simply shows you settled. Either way, it still points to the fact that you may be a credit risk. But again, so does not paying your debt to begin with. Also keep in mind that this is likely better for your score (though we can’t say by how much) than paying nothing and waiting for the debt to drop off your record.

How Potential Lenders View Your Settled Debt

A lender might look at your attempt to repay as a good sign. Others may still see you ask a risk; it all depends on the lender. Some mortgage companies, for example, actually require borrowers to pay off old debts before closing on the loan.Again, a partially settled payment is still considered negative activity. If you want to pay the debt in full to avoid the hit to your credit, it’s best to do it before the debt is actually sold, or “charged off.” This way, the debt will show as late, but it will also show that it’s been paid in full. After it’s sold to a collections agency, though, the bulk of the damage has already been done.

“If the account has not yet been charged off, you may be able to negotiate settlement of the debt if you are unable to pay it,” Griffin says. “Settling a debt will still have a significant negative impact on your credit scores, but it may be slightly better than allowing the debt to be charged off as a loss and sent to collection before negotiating settlement.”

Other Factors to Consider

You also want to consider the statute of limitations on your debt. Most past debts remain on your credit report for seven years, so if you’re close to the time frame when the debt falls off, settling it may not make much of a difference. There’s an ethical argument to be made here, but practically, you might just be settling a debt that was about to disappear anyway.

Your credit score will take a hit when you settle, but Griffin says “just how significant the score impact depends on each individual’s unique credit history.” In other words, the hit your score takes will depend on how high it is to begin with. Generally, the higher your score, the larger of an impact negative activity has on it.

Either way, when dealing with a debt settlement company, you must get all of your terms in writing. You might even be able to negotiate the language they use to report the activity to the bureaus. Some will agree to report that you’ve satisfied the debt in general, which might be a little better than a “partial payment.” Again, it very much depends on how a lender prefers to interpret that activity. Your discretion may differ from theirs.

Beware of the Tax Hit

Another factor to consider when settling your debt is taxes. If the amount of debt that’s forgiven is more than $600, the IRS will probably mail a 1099-C “cancellation of debt” form to you. This means you’ll have to report the amount as taxable income. In short: yes, you’ll owe taxes on it.

If the forgiven amount is significant, that could mean a big bill around tax time. If that stretches your finances thin, you want to be careful that you don’t go back into debt or get behind on any other payments.

Generally, debt settlement can be complicated, and it’s not the financial cure-all that people often assume it is. Knowing how it works can help you make the best decision for your own situation.

Kristin Wong writes and makes videos about all things money. You can find her writing at Lifehacker,, and on her own personal finance blog, Brokepedia.

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