It may be legal to settle your debt for less than what you owe, which is what "settled" means on a credit report, but it might mean trouble for you. Settling your debt may be better than filing for bankruptcy, but you should know all the ramifications of settling as well as how to avoid being ripped off.
When you settle your debt with your lender for less than what you owe, your lender reports this information to the credit-reporting bureaus. When you want to take out a loan in the future, apply for a job or rent an apartment, the person who reviews your credit report will see that you settled a past debt. This sends up a red flag, or a warning, to the lender that you might not be a good risk, and the lender might turn you down or charge you a high interest rate.
Lowered Credit Score
Not only will lenders see that you settled a debt when they view your credit report, but your credit score will be lower because of the settlement. Lenders do not typically settle with you unless you are behind on your payments. If you are making your payments each month, the lender has no reason to settle. But if you are behind in your payments, some lenders would rather settle with you than not receive anything if you file for bankruptcy. However, once you are late on your payments, your credit score drops. Payment history makes up the largest percentage of your credit score, 35 percent.
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Working With Lender
When you negotiate with your lender to settle your debt, you can ask the lender to report this favorably to the credit-reporting bureaus. Your creditor can mark any account that is late to show that the account is in good standing, according to Bankrate.com. Before you give your lender any settlement money, you could request a written statement that will show how it intends to list your account on your credit report. Your lender does not have to agree to this, but it doesn’t hurt to ask.
When Settling Backfires
If you do try to settle your debt, it could backfire on you, and your creditor could sue you. A lender does not have to agree to settle with you. The lender could decide to sue you for the amount you owe. The only way to avoid a bad mark on your credit report if that happens is to pay your debt in full. If the lender does accept your settlement, the Internal Revenue Service considers any amount you did not pay that is more than $600 taxable income. The IRS will not settle with you or forgive your debt.
Beware of debt settlement companies. In theory, these companies are supposed to negotiate your debt with your creditor. But in practice that doesn’t really happen, says Katie Porter, a bankruptcy law professor at the University of Iowa, in an MSN Money article. You are supposed to be putting money in an escrow account with the settlement company, but many times the company is simply withdrawing fees and not settling your account. In addition, once your creditor discovers you are working with a debt settlement company, the creditor often escalates your account or sues you, at which point the settlement company may drop you as a client.
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