How Would Debt Settlement Affect My Credit?

“How is this going to affect my credit rating?”

It’s not the sort of question you expect to be asked from someone looking around for a solution to his or her financial problems, is it? But if you were to survey credit counsellors, Debt Arbitrators and even bankruptcy trustees, you might be surprised to learn that this is one of the first questions asked almost every single time.

And that’s a good thing. It shows that in spite of everything – be it overwhelming debt loads or collection calls or reduced income or whatever the financial crisis may be – there is a spirit of optimism and hope for the future: “Please help me get past this, and everything will be all right,” is the real statement. The debtor may not consciously realize it, but he or she is already looking past the current ugliness to a happier future.

OK, that’s the warm and fuzzy answer, but what’s the real scoop? Is debt settlement going to affect my credit rating? And the short answer is, yes, it will.

Maybe a follow-up question might be, “Will debt settlement affect my credit rating less than any other option?”

Well, excluding debt consolidation - which is the best solution – the answer is a resounding yes!

The fundamental credit bureau rating is on a 1 through 9 scale. 1 means you’re very good, never missed a payment, etc.: you appear to be a ‘good’ credit risk. 9 is the other extreme, a written off account, in collections and so on. The numbers 1 to 5 are a progression of your paying habits from very good to very bad. There is no value assigned to 6, it is simply an empty category. If you were to go through debt counselling, you will be recorded as a 7 on your credit bureau history. 8 is a repossession, and 9 we’ve already discussed. If you were bankrupt, that will show up as well. As for debt settlement, you will have whatever rating you were at when you went to a debt arbitrator: that’s your history and you’re stuck with it. However, once a successful settlement has been negotiated, the creditor reports you as ‘Settled’ and with a zero balance.

Your credit rating is determined by a whole bunch of factors. Primary among them is your payment history and your debt-to-income ratio (or how much debt you have). As we’ve seen, there’s not much that can be done to change your payment history: whether it’s good or not so great, it’s your record. The good news is that it eventually falls off entirely. Your debt-to-income ratio, however, is positively affected by settling your debts. As said, each debt that is settled is reported to the credit bureau as a ‘zero’ balance.

So if you’ve managed to settle a $6000 credit card balance for, say, $2000, your report will not show an outstanding balance of $4000, but rather $0. This reduces your overall level of debt which of course improves your debt-to-income ratio. And that specific portion of your credit score (a separate measurement of your credit worthiness from the standard 1-through-9 scale) improves.

Remember, debt settlement is an alternative to a credit counselling program and bankruptcy. It may adversely affect your credit if your debts are current and you have no history of late payments. But if either credit counselling or bankruptcy are already being considered, the credit history is not going to be great to begin with. In the end, the debt settlement option improves your debt-to-income ratio and therefore improves that portion of your credit score. Since you will have resolved your outstanding debts your future creditors will see that you settled instead of either going through a credit counselling program or assigning into bankruptcy.

We do recommend against applying for new credit while working with a Debt Arbitrator. It doesn't make a lot of sense to take on new debt while you're trying to resolve your existing debt problem. If your history is already poor, you aren’t going to get the new credit anyway. You could very well have a high credit score due to a clean payment history (even though it may have been financially drowning you to keep up the payments) and still be denied a new loan because you carry too much debt.

Contrary to popular belief, good paying habits alone don’t necessarily translate into ‘good credit.’ In fact, they only account for perhaps 30% of your overall credit score. Here are a few other factors that you would probably never believe would lower your credit score, but they do: making minimum monthly payments on your credit cards for several months; credit cards charged to their limit (major impact!); too many recently opened accounts; too many open accounts (Note: closing your open but zero balance accounts may also negatively impact your credit score if it increases your total debt to total available credit ratio to above 50%).

So your debt-to-income ratio is critically important to the well-being of your credit history and your ability to get credit. By successfully negotiating settlement of your debts, your debt-to-income ratio will improve dramatically.

So what does all this mean?

Well, here are a couple of things to think about.

First of all, you really don’t have a choice to make: whatever your current circumstances are pretty much dictates which route you are going to take to resolve your debt problems. Any route you take, other than debt consolidation, is going to have an impact on your credit rating: bankruptcy is clearly the worst, followed by debt counselling, and then debt settlement. And this information stays on your credit bureau history for up to six years. Each of these options is distinct from the others as each is a specific solution for a specific situation. And the solution is ultimately what you’re looking for. Each has a downside, but the fact remains that all three are wonderful solutions, and one of them will solve your problem. So if you look at your situation from a solution-based perspective instead of what possible negatives there are, it kind of clarifies things: you’ve got a problem, you need a solution, you’re limited in your choice of solutions, you choose (or more probably are only eligible for one) for one of them, your problem is solved. So whichever solution works for you, for goodness’ sake take it. Everything else – especially the unnecessary worry over your credit rating – is a distant second.

Regarding your credit rating, it’s not an immediate issue. If you’re looking at consolidation, credit counselling, debt settlement or bankruptcy,

  • you’ve got a problem;
  • you certainly don’t need more credit;
  • you can’t get more credit anyway;
  • your credit history is almost certainly reflecting something less than ideal.

If your credit bureau history is already showing a delinquent payment history or a poor debt-to-income ratio, it will get worse – as said above – if bankruptcy is your only alternative or if you opt for credit counselling, but won’t if you go for debt settlement (it will only adversely affect you if you’re up-to-date and always have been, and you have a favourable debt-to-income ratio; but if you did, you wouldn’t be reading this because you clearly don’t have a debt problem).

Now here’s something you really have to think about: the worse your credit rating is at the time of signing up with a Debt Arbitrator, the less debt settlement will adversely affect it. The fact is, in order to obtain a good settlement, an account first needs to be past due. As we’ve discussed, how debt settlements affect your credit rating depends on several factors. The primary factor has to do with how your credit rating is now. However, if you already have accounts that are three + months past due, it should not affect your credit any worse than it already is.

It all comes down to ‘recovery time,’ the time it takes before you fully return to the credit ranks. With bankruptcy it takes years. You can probably begin getting limited credit (pre-paid credit cards, secured loans like a car loan, co-signed loans) early on, but it will be a long time before you will be able to get an ordinary credit card or line of credit or signature-only loan. Much the same can be said for credit counselling programs. They are good, but until that 7 drops from your history, you’re going to be faced with limitations.

With debt settlement, recovery is a lot faster. Once the debts are resolved, the account balance and payment due are reported as zero. This has a positive impact on the account and credit history and particularly the debt-to-income ratio, especially over the long-term. The reason is that negotiated settlements are viewed more favourably than unpaid past due accounts. The history of the delinquency up to that point remains, but the account moves from the current derogatory section of the credit report, to the closed section. As months pass any derogatory history has less and less influence on the credit score. The belief among lenders is that after 12 months these settled accounts are given very little consideration. It appears that provided all other debts are paid in a timely manner (house, car, other accounts kept current) that the effects of the settlement process are temporary, and you can be back to the world of credit in a much shorter period of time than any by any other option.

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