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If you settle debt, expect a credit score drop

Dear Speaking of Credit,
I am currently in $60,000 of credit card and loan debt. I am considering a debt negotiation that would close and settle seven accounts. I have never been late and my credit score is only 650. How will settling debt on multiple accounts affect my credit score? And for how long? Thank you. – Jane Doe

Dear Jane Doe,
When you settle debt on multiple accounts, expect to see the description of “settled” or “settled for less than the full amount due” appear on your credit report for each account. Having never been late has helped prop up your credit score, and you are to be commended for your diligence. Yet, regardless of how an account was paid before settlement, the credit scoring formulas treat settled accounts much like charge-offs and other balances not paid according to the original agreement – badly.

The score drop
With the first appearance of a settled account on your credit report, expect to see a relatively quick drop of 40 to 60 points in your score. Then after the last settled account has made its way to your credit report, your score should begin its slow-but-steady recovery with on-time payments, low credit utilization (card balance/credit limit ratio) and an increasing length of time since the last reporting of a settlement or other negatively reported item.

The score recovery
How long should you expect to be saddled with a low credit score following a debt settlement? It's tough to say, for several reasons. Each situation is unique. The various credit scoring calculations are complicated proprietary business secrets. Still, if you do nothing more than pay any remaining debts as agreed without adding new accounts, a conservative estimate would have your score in the high-600s when your latest account settlement hits the two-year mark and at 700 or above when at least three years have gone by.

Expediting the score recovery
You can speed up the rebuilding process, however, by employing one or both of the following strategies, as the passage of time automatically continues to do the most critical score recovery work for you:

  • Pay off and leave open any additional credit cards on which you owe, particularly if settling those debts leaves you with some additional funds at your disposal. Doing so could lower the remaining credit utilization percentage that makes up almost 30 percent of your credit score and raise your post-debt-settlement score a little faster than if paid more slowly over time.

  • If settlement of those seven debts leaves you without any open cards or loans, you could give a little extra help to your score by opening a secured card or installment loan that is reported positively to all three major credit bureaus – Equifax, Experian and TransUnion. The addition of “good” credit to your credit report in this way can bring more points to your score through the scoring factors that evaluate the proportion of good accounts to negatively-reported ones.

Tax consequences of debt settlement
Along with how bad your score may get and how long its recovery is likely to take following one or more debt settlements, you might also face some tax consequences when resolving any amount of debt in this way.

Many consumers whose debts are eliminated through a settlement find they later get an unpleasant surprise. They discover that, in the eyes of the IRS, any such forgiven amount – the difference between what you owe and the amount accepted as payment in full – must be included as income on that year’s tax return, though exceptions are made for insolvency and other financial hardships.

When $600 or more is forgiven, the lender will send a 1099-C (Cancellation of Debt) IRS form for your tax filing. Since adding any such amounts to your income earned in that year can seriously affect your tax liability, you will want to consult a tax preparer familiar with such tax consequences arising from debt settlement and play it safe by setting aside at least 10 percent of the forgiven amount for Uncle Sam.

See related: Will debt settlement hurt authorized user's credit?, Minimizing score damage after a charge-off, Where to turn for help with overwhelming debt