Mending a credit score hurt by a student loan default

Dear Credit Score Report,
I have been offered to settle a student loan that I co-signed and that later went into default. The offer is that once the settlement amount is paid, they will report to all the national credit reporting agencies that the charged-off loan has been repaid for less than the full balance. (This is besides reporting to the IRS the unpaid balance as a 1099-C, which I am aware of.) This is the only negative mark I have on my credit report, so my question is: If I decide to settle, will my pristine credit score be restored? Is it really worth doing it, or is there a way I can negotiate for them to remove it completely from my history? I appreciate your feedback. — DiDi

Hey DiDi,
Repaying a debt for less than the original loan amount will cause your credit score to drop. But by making repayment — and by being more careful from now on — you can encourage your credit score’s recovery.

As you’ve found out, having a loan account charged off is awful for your credit score. But repaying a portion of that loan isn’t going to restore your credit score, regardless of what the lender or debt collector may say. (Typically, negative items remain on a borrower’s credit report for seven years.) In fact, repaying only a portion of that student loan could further lower your FICO score, the credit score used most often by U.S. lenders. “An account reported as having been settled for less than the full amount due is treated negatively by the FICO scoring formula, as are most situations where a debt is not paid according to the terms of the original agreement,” says Barry Paperno, consumer operations manager at myFICO.com. That means settling your loan won’t bring your old score back, at least not right away. However, by repaying — either in one lump sum or over the course of many months — and being careful with any other debts, you will (eventually) experience credit score recovery.

Before we discuss your next steps, I’d like to first make sure you’ve learned just how dangerous it can be to co-sign on a loan: By becoming a joint account holder, you put your own credit and financial health at risk when that loan went into default, regardless of who’s to blame for not making those payments to the lender. I hope you won’t ever put yourself in harm’s way like that again.

Now that the damage is done, however, it’s time to rebuild. Your willingness to pay is important, but even more important, do you have enough cash for a single, large payment? You’ll need that money for the settlement — or when negotiating what’s called a “pay for deletion” with the debt collector. (I’m not sure if you’re still dealing with the original lender or a debt collector.) Under such an arrangement, you get the collection agency to agree to a single payment in exchange for taking the negative marks off your credit report. Make any such requests to the collection agency in writing.

There’s no guarantee that strategy will work. “Of course, it’s also possible that the collection agency will deny such a request and continue to demand payment for either the full or partial amount due — with no agreement to remove the item upon payment,” Paperno says in an email. “And even if the collection [item] is removed, it should not be assumed that the score will benefit as long as the original student loan continues to be reported as a charge-off,” he says.

What other options do you have? You may want to consider loan rehabilitation. In order to rehabilitate the loan, you’ll need to make nine timely, consecutive payments over a 10-month window. That process will cure your default and remove the negative notation from your credit reports. Your original delinquencies that led to the eventual charge-off will remain on your credit reports, however. (For more on loan rehabilitation, see “Steps to make good on a defaulted student loan.”)

In the end, however, you may end up choosing to settle. In the short term, that decision will cause your credit score to fall. Just how much will it hurt? Settling on a debt will lower a FICO score of 680 by 45 to 65 points and a FICO score of 780 by 105 to 125 points.

Over time, though, a settlement should help. “While this action won’t immediately restore her credit score, settling this debt should enable her to begin the process of restoring her credit, which can be accomplished by continuing to pay all other accounts on time, keeping credit card balances low and only opening new accounts when necessary,” Paperno says.

Regardless of what option you choose, just remember that when rebuilding your credit following a charge-off, settlement or borrowing mistake, it helps to take a longer-term view rather than expecting a quick fix.

Good luck!

–Jeremy

See related:Cure your defaulted student loan in six steps, FICO reveals how common credit mistakes affect scores, Steps to make good on a defaulted student loan, 1099-C surprise: IRS tax follows canceled debt