Paying off in full vs. settling maxed-out card debt

Speaking of Credit with Barry Paperno

Barry Paperno is a freelance writer and credit scoring expert with decades of consumer credit industry experience, serving as consumer affairs manager for FICO and consumer operations manager for Experian. He writes “Speaking of Credit,” a weekly reader Q&A column about credit scoring and rebuilding credit, for CreditCards.com. His writings about credit scoring have appeared on Huffington Post, MSN Money, CBS Money Watch and other consumer finance websites.

Ask Barry a question, or see if your question has already been answered in the Speaking of Credit answer archive.

I have a lump sum I can use to pay off maxed-out cards. Should I pay them in full or settle for less?

Since both paying in full and settling will eliminate your credit card debt, you should consider cost savings and the impact of your score of each possible option.

However, settling usually becomes an option only when the debt has been written off as a loss by the bank. In that case, the impact of settling on your score will depend on whether the debt:

  1. Has been reported as charged off, or 
  2. Has been sent to collections.
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Dear Speaking of Credit,
I just got lump sum of cash from parents to pay off some credit cards I have maxed out. Should I try and settle with credit card companies, or should I pay in full? 

Reason I ask is because my credit has gone down almost 200 points to 498 over a two-year period. Would it hurt even more if I settle debt? – Octaviano

Dear Octaviano,
I’m afraid that, yes, in some situations settling a debt could set your score recovery efforts back a bit.

However, doing so could save you a lot of money that could be put to good use elsewhere.

So let’s look at how these two considerations may sway your decision of whether to pay in full or settle:

  • Cost savings
  • Score recovery

Fortunately for once, we can leave the amount you owe out of this discussion, since both paying in full and settling will eliminate your card debt.

Both options will also get rid of any lingering score damage caused by having card accounts with such a high credit utilization – the amount you have borrowed compared to your credit limits.

Credit utilization is the second most important factor in credit scoring, after making on-time payments.

Now let’s look then at how a negative payment history – recent history, especially – might be affected by either an in-full payoff or a settlement.

Cost savings of paying off card debt

Like it or not, paying full price is often the quickest and most convenient way to resolve a problem account.

This is especially true when you can skip the usual back-and-forth negotiating routine leading to an agreed-upon debt settlement. 

What can go wrong with paying less? Often, nothing. That is, as long as you’re aware of some hidden cost pitfalls that can come with settling any debt:

  • Taxes on “forgiven” debt. If over $600, you will receive a 1099-C Cancellation of Debt tax form from the creditor or collection agency. The IRS requires that you report any amount of forgiveness for that tax year, as it is considered income. When added to your taxable income, the money you just “saved” via a settlement could cost more than anticipated.
  • Fees from debt settlement companies. By receiving a lump sum from your parents, you shouldn’t need the services of a debt settlement company that typically helps consumers save money over time and later negotiates debt settlements on their behalf. These companies typically collect monthly savings contributions from their clients, along with a monthly service fee that is not applied to the eventual debt settlement.

Score recovery due to paying off card debt

While we know your score has dropped almost 200 points to 498, and your cards are maxed out, we don’t know how timely you’ve paid these cards in the past.

Yet it’s doubtful that a score with a good payment record will drop by that many points solely due to high utilization.

For that reason, we will assume here that you’ve had some degree of payment problems along the way – either currently or in the past.

Paying in full isn’t always just simpler and more convenient than negotiating a settlement. Depending on the stage of delinquency and for how long these problems have gone on, paying all of what’s due on a card can sometimes make for a quicker score recovery.

Settling debt usually becomes an option once the debt has been written off as a loss by the bank, and not until then.

Therefore, let’s consider these two resolution options on cards that fall within last two stages on the troubled card timeline: charge-off and collection.

Tip

Tip: Once a card debt has been sent to collections, the impact on your credit score is the same whether you decide to pay off the debt in full or settle with the collection agency. If you want to protect your credit score, make an effort to pay your card debt before it is sent to collections.

When card debt is reported as charge-off

Once a charged-off debt has been settled, the creditor will typically begin reporting the account to the credit bureaus as having been “settled for less than the full amount due.”

And just as the score sees a charge-off as a derogatory event, it also sees a settled account in the same way, despite the debt having essentially been wiped out.

As you may already know about credit scoring, the length of time since an account encountered payment problems can be one of the most critical negative factors in a credit score. That is, a recent negative item can be expected to cause much more score damage than an older one.

This is why scores tend to improve over time once problems have been resolved.

So, when a card goes from being reported as a charge-off to being settled, though the outcome is better, the more recent settlement date on the negative item can lead to a lower score than it was prior to settling, as part of the “time since the most recent delinquency” calculations.

When card debt is sent to collections

Whereas a recent debt settlement can hurt the score when replacing a charge-off as the latest negative status, the worst, and last, step along this timeline is much less complicated.

Using the most widely used FICO models, once a bad debt has been sent to a collection agency, it will no longer matter to the score whether the debt is ultimately paid in full or settled. Unlike a debt settled at the charge-off stage, no such reporting change occurs when a collection goes from unpaid to either paid-in-full or settled.

The date the debt was assigned to the collection agency tends to be the only date that will ever be used to measure its recency, regardless of the eventual outcome.

Things to consider when paying off card debt

What this all means is that when considering the merits of a payment in full versus a settlement, be sure to carefully weigh:

  • The true cost of a settlement, including taxes and perhaps debt settlement company fees.
  • The impact of the debt resolution on your score’s recovery, particularly when settling a pre-collection charge-off.

Most importantly, you’ll be getting out from under that debt and getting on with your life.

Just be sure to thank your parents and do something nice for them!

See related: Paid a charged-off debt: now what?, How to restore credit after maxing out cards


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Updated: 10-20-2018