Will paying off a debt hurt your credit? -Forbes | Vette Leader

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Debt service allows an overburdened borrower to repay a loan in a lump sum that can be significantly less than what is owed. It’s a tactic that can banish a dark cloud hanging over your finances. But be wary that a new source of gloom may emerge, because paying off debt can be bad for your credit score.

The credit reports that are used to calculate your credit score will show a black mark for any debt that is paid for less than the full amount. So while paying off a debt can offer great relief, it can also cause major problems if you need to re-borrow, since lenders generally use credit scores to decide whether to roll over loans.

But don’t assume that paying off debt is always a bad idea. A lot depends on the circumstances. Here’s a look at how debt settlement works and how it may affect your access to credit, along with tips for choosing a financially healthier alternative.

What is Debt Settlement?

In paying off a debt, you agree to pay part of a debt and your creditor agrees to brush the rest off. There are several ways this can come about.

A debt settlement company may offer to negotiate with your lender to get you a good deal. But the Consumer Financial Protection Bureau warns that working with debt-repayment firms can be “risky,” as the federal regulator says they often charge hefty fees and encourage consumers to stop paying their bills in hopes of impacting to take the lenders.

You could end up with less money and worse credit than before, and little or no debt relief.

Homemade debt settlement is another option. Consumers can contact creditors themselves and ask if paying in installments would settle a debt. This works best for claims that have already been written off as uncollectible by creditors.

Sometimes the creditors take the initiative to pay off the debt. You can approach a customer and offer to take a reduced payout as a last-ditch effort to settle an account that is long overdue.

Whether it’s through a comparison firm, through a do-it-yourself contact, or in response to a creditor’s offer, paying off debt can result in dramatic savings of 25%, 50%, or even more on balances owed. It may be worth considering. But you also need to consider the potential impact on your credit score.

How Paying Off Debt Can Affect Your Credit Score

The problem with paying off debt is that when a creditor accepts less than the amount owed, the account isn’t quite marked as fully paid on the borrower’s credit report. Wording varies by credit bureau. TransUnion may refer to the payment status as “Paid after debit” while Experian says “Account legitimately paid in full for less than full balance”.

Different credit scoring models also treat debt repayment differently.

But the effect of paying off a debt by installments is usually negative, often significant. That’s because payment history is the single largest factor in calculating a credit score, accounting for 35% of the result.

According to the National Foundation for Credit Counseling, debt settlement practices can lower your credit score by 100 points or more. And that black spot can last up to seven years.

Much depends on the circumstances. For example, a consumer with an already poor credit score due to a history of late payments and collections won’t be as harmed by paying off a debt as someone with a near-pristine FICO score of 800. And sometimes, paying off debt can even help, at least in the medium term.

How Paying Off Debt Can Help Your Credit Score

One benefit of settling an account is that it prevents the creditor from reporting updates to the major credit bureaus. This begins the period of up to seven years that “disparaging information” may remain on your credit reports.

Another benefit of paying off a debt is that the balance does not affect your credit utilization, which is the amount of your available credit that you are using. High credit utilization depresses creditworthiness. Debt settlement eases this pressure.

The judicial settlement of a claim also prevents the creditor from suing the claim – a clear plus. When a creditor contacts a borrower with a settlement offer, it can be a signal that the lender is seeking an appeal. That alone is reason enough to seriously consider a settlement offer from a creditor.

When you settle a claim that a creditor has assigned to a collection agency, you can arrange for the collection agency to report the account to the credit bureaus as “fully paid” and delete from your credit files derogatory information about the settled claim.

The collector may deny both requests, but it’s worth asking because you could win twice: you avoid paying off the debt completely and protect your creditworthiness from major long-term damage.

Or the collector could send you back to the original creditor to make your case for removing the black spots from your credit reports. You must show that you are making a serious effort to be more responsible about lending.

Alternatives to paying off debt

If you are not seeking debt settlement, you have other debt relief options that may be less damaging to your credit score.

You could negotiate with a creditor for what is called a structured debt settlement. This type of arrangement can give you more time to pay off the debt and even lower the interest rate. The outcome can be as positive as paying off a debt, but without hurting your credit rating.

A debt consolidation loan offers a way to restructure debt without creditor approval. Consolidation replaces your existing debt with an unsecured personal loan or home equity loan borrowed against your home.

These loans can lower the interest rate on your debt and extend your repayment period, saving you money and reducing short-term liquidity pressures. However, be aware that if you can’t pay off a home equity loan, you could lose your home.

A similar step is to get a new credit card with an introductory rate of 0% and transfer debt to the card. This can save you a lot of money on interest and will not harm your payment history.

Perhaps the wisest step is to take your debt problem to a nonprofit consumer credit counseling agency. These experts can help you with budgeting and also negotiate new terms with creditors while holding lenders accountable and managing your payments to keep accounts current and improve your credit score.

Bankruptcy is the most drastic approach to overwhelming debt. Chapter 7 bankruptcy can completely and permanently wipe out most unsecured debt, usually without payment. However, a black mark from a Chapter 7 bankruptcy remains on a credit report for 10 years.

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bottom line

Debt settlement can help borrowers pay off old debts, often for much less than the full amount owed. While it can save you cash and reduce your stress, paying off debt can be costly on your credit score and make it harder for you to obtain new credit for years to come.

If you’re saddled with unsustainable debt, settlement is one possible solution to consider, but others may be less damaging to your credit score.

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