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Does Settling Credit Card Debt Hurt Your Credit Score?

Posted By Jim On 08/03/2010 @ 2:57 pm In Credit | 17 Comments

Reader Dan told me a story of his friend who was considering settling an outstanding credit card debt but wasn’t sure of the credit score implications:
(Dan): my friend owes like $1100 on a credit card, and he had the balance for like two years and didn’t pay a dime, because he felt he was being taken advantage of
(Dan): well, he went to lease a car last weekend and found out the importance of credit
(Dan): he had bad credit and his new wife basically had none
(Dan): I told him step one would be to clear his balance
(Dan): he called just now, and he mentioned (in IM) something about them offering to settle for like, $700?
(Dan): does settling affect your credit score?

There are a few things going on here at once but in general, settling a debt will improve your credit score. It sounds counter-intuitive but it’ll make sense in a few sentences.

In order for a creditor to even consider a debt settlement, you have to be behind on payments for them to believe you won’t pay at all. This is actually a tactic used by debt settlement companies [3]. When the creditor doesn’t think you’ll pay, they sell it for pennies on the dollar to a collector. If you can pay tens of pennies on the dollar, they’ll take that as the next best thing to paying in full.

The problem is that when you fall behind, your credit will be hammered mercilessly. If the creditor sends it to collections, your credit will sink. The reason your score can go up if you settle is that the account will go from “delinquent” to “paid, settled for less than amount owed,” which is an improvement. It’s worse than “account paid in full” but it’s better than “delinquent.”

Debt settlement experts often recommend that you send a “pay for delete” letter, which is basically an agreement that they will delete the account (and the record of it on your report) in return for paying the amount due. They also recommend that you pay less than 50% (anywhere from 35-50%) of the amount due.

Whether or not that’ll help Dan’s friend get the lease is another issue, having a two year old delinquent account can’t be good and moving it into the “paid, settled” category probably won’t help him too much in the short term.


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