Does It Affect Your Credit Score if You Settle for Less Than You Owe?

••• Jupiterimages/BananaStock/Getty Images

Your credit score reflects your historical ability to manage your financial obligations to lenders, whether they were incurred to finance a car, fund your lifestyle on a credit card or buy a house. An account that is settled for less than the balance owed has a negative effect on your credit score, but you can take steps to minimize the damage.

Why Lenders Frown

Settling for less than you owe is a sign to prospective lenders that you may not repay their loan. It represents a broken agreement with a previous creditor that resulted in you paying back less than you borrowed, which indicates both that you’ve had trouble managing credit in the past and that you’re not a stickler for honoring your obligations. If you've shown that you've done this to other creditors, lenders worry that their accounts will suffer the same fate.

Context is Key

The negative effect of settling an account for less than you owe depends on the context. A quick settlement can be overcome faster than one that didn’t take place until your account was more than 180 days past due. If the account is in collection and has been sold to a third party, it’s often easier to negotiate settlement terms, but it also means it appears on your credit report twice, as a charge off from the original lender and as an entry noting it was sent for collection. If this account is your only delinquent account, you’ll see your score improve faster than if your credit report shows multiple problems, particularly if you have an extensive history of positive credit use elsewhere.

Best Bad Option

While a settlement negatively affects your credit score, it may be the best option among a litany of bad options. If the balance is considerable and even the minimum monthly payment stretches beyond your budget, settling the account at least avoids another few months of delinquencies. It also gets the account off the books a little bit sooner, and as you build your credit history back up with your remaining open accounts, older blemishes have less importance.

Negotiate the Wording

The key to minimizing the damage a settlement does is to negotiate how the creditor reports the transaction. If the lender agrees to report the debt as “Paid as Agreed,” “Current” or something similar, it raises fewer red flags on your credit report than "Settled" or "Charge Off." This isn’t always possible in a negotiation and may require you to sweeten your settlement offer or pay in a lump sum. Get any agreement in writing and check your credit report for confirmation that the creditor has fulfilled its agreement.