Credit score impact of settling a debt or paying it in full

By Erica Sandberg

Opening Credits

Erica Sandberg is a prominent personal finance authority and author of "Expecting Money: The Essential Financial Plan for New and Growing Families." She writes "Opening Credits," a weekly reader Q&A column about issues for people who are new to credit, for CreditCards.com. Ask a question. 'Opening Credits' stories

Dear Opening Credits,
I have an account that was sold to a debt acquisition company; they've offered a settlement amount. Should I pay it or pay the original balance in full? They state that no matter how I chose to pay the account, it would reflect as paid/satisfied.   -- Maxi 

Dear Maxi,
If your aim is to save money and put an end to demanding calls, go for it. However, if it's to perfect your credit report, wait up.

I like debt settlements, primarily because I'm a sucker for a great deal. Why pay retail if you can get the sale price? In essence, that's what a settlement is: your debt on the bargain rack.

Collection agencies often let people who owe them money pay less than the actual balance for a couple of reasons. One, when you agree on an amount that is more than what they purchased the account for, they still turn a profit. That makes them happy. Two, they get to lay the account to rest. It takes considerable time and effort to "inspire" people who owe them to send the cash. When you finally shake hands and send the money, they're free to move on to others on their books.

So what happens to your credit report when you do make this kind of arrangement? As the collector stated, the account will show up on your report indicating that the debt has been satisfied or paid. But this doesn't mean that a magic wand wipes your reports clean and clear of damage.

Like it or not, all credit report subscribers -- banks, collection agencies, the IRS, etc. -- are required to only submit true and current information about a consumer to the bureaus. If they didn't, the reports would be worthless. After all, the only reason an individual or business buys them is to get an accurate read on a potential customer.

If a collection agency lies and says that you paid $1,000 when in reality you only sent in $500, the report would be false. Typically, a collection agency would send a "debt settled" or "partial payment accepted" notation to the bureaus. They can also say that you've satisfied the debt (which is kind of a nebulous statement) and owe nothing more (which is accurate, because that's the agreement you made).

Even with the settlement notation in place, though, a lender may perceive it favorably. That you no longer are obligated to pay a big balance can be positive as it frees your capacity to borrow more. Then again, others may find it negative, since it shows that you didn't pay per the initial contract.

Another issue is that the derogatory information from the original account will continue to show up for seven years. Your credit reports will list the late payments and then the date they charged the debt off and sold it to the collector until that timeframe has run its course.

Plus, the amount of forgiven debt may have tax implications as it is considered income in the eyes of the IRS.

Regarding your credit score (such as the one developed by Fair Isaac called the FICO score), settlements are a factor in their mathematical equation. It doesn't matter how much you walked away from, just that you did. FICO doesn't reveal just how many points it will drop from your score if you settle, but it is clear that the higher your credit score is, the more that action will hurt. Therefore, if your numbers are already low, you probably won't see much effect.

To get an idea of what the credit score impact could be from a debt settlement, you may want to check out the chart in this story, "FICO reveals how common credit mistakes affect scores."

So it's up to you. Do you want those who pull your credit report to see that you've repaid every penny you owed, or would you rather take the deal and be done with it? The choice is yours.

See related: Settling delinquent debt won't remove it from your credit report, Video: The basics of debt settlement

Erica Sandberg's articles and insight are featured in such publications as the Wall Street Journal, Pregnancy, Babytalk, Redbook, Bank Investment Consultant, Prosper.com, MSNMoney.com, and Smartmoney.com. An active television and radio commentator, Erica is the credit and money management expert for San Francisco’s KRON-TV, a frequent guest on Forbes Video Network, Fox Business News, Businessweek-TV, and all Bay Area networks. Prior to launching her own reporting and consulting business, she was affiliated with Consumer Credit Counseling Services of San Francisco where she counseled individuals, conducted educational workshops, and led the media relations department. Erica is a member of the Society of American Business Editors and Writers, and on the advisory committee for Project Money.

Send your question to Erica.

Published: February 20, 2013

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