How Does Settling a Debt Affect My Credit Score?

Outstanding unpaid debts can do big damage to your credit score, so it’s a good idea to try to resolve them as quickly as possible. Creditors and debt collectors may be willing to work out a repayment plan or even settle the debts for less than what you owe. But can paying this lower amount cause extra damage to your credit?

Unfortunately, the answer is yes.

“Generally speaking …. paying in full as soon as possible is the best action to take in terms of … preserving the credit score,” Barry Paperno, a credit expert who blogs at Speaking of Credit, said in an email.

A debt settlement, conversely, could have a negative effect on your credit score.

“The precise impact of a debt settlement on the score will depend on how this specific information is reported to the bureaus as well as on the remaining information on the credit report,” major credit scoring model FICO said in an email. “FICO research on millions of credit files has found that consumers who do not pay off their loans per the original terms of the agreement represent higher risk to lenders, and as such, if the debt settlement is reported in the credit file with an indicator that the account was paid for less than the full amount owed, that can be viewed as a derogatory indicator by the score.”

An Important Caveat

But that’s not to say that settling for less isn’t your best course of action. Failing to make good on your balances could cause a creditor to take further adverse action against you. They might charge off the debt or resell it to a collection agency. And both collectors and creditors could sue and ultimately secure a judgment against you to get repayment for the debt.

Newer credit scoring models, including FICO 9, ignore paid or settled collections. These scores, however, are yet to be in widespread use, so there’s still a good chance a collection account will do more damage to other versions of your credit score.

And, when it comes to judgments, “the impact … on the FICO Score is primarily driven by their presence as opposed to their status (e.g. paid-in-full vs. settled),” Can Arkali, principal scientist at FICO, said in an email. “So, if the debt can be satisfied in advance of the judgment filing, that could prevent a more adverse impact to score which might arise if an additional judgment is posted to the credit file.”

In other words, “damage control … i.e. paying as much as you can as soon as you can” should be a major consideration for consumers looking to resolve unpaid debts, Paperno said.

Deciding What to Do

In weighing your options, it’s a good idea to ask the creditor or collector in question how they plan to report any settlement they are offering to the three major credit reporting agencies. You can also try asking if they will remove the collection account in exchange for payment.

If you negotiate a deal, obtain written confirmation of your agreement. And, once you have paid, keep an eye on your credit reports to be sure the account is appearing as agreed. (You can do so by pulling your credit reports for free each year at AnnualCreditReport.com; You can also see what effects the resolution may be having on your credit scores by viewing them for free each month on Credit.com.) If you see the debt is being reported inaccurately, you can file a dispute with the credit bureaus. You can go here to learn more about disputing credit report errors.