How Can Debt Settlement Affect My Credit Score?

If you’re heavily impacted by consumer debt and don’t know where to turn, you might be considering a dramatic option like bankruptcy or a consumer proposal. While those tools are helpful for some Canadians who are overwhelmed by debt, bankruptcy strongly impacts your credit score and should be considered a last resort option.

Debt settlement is an alternative debt repayment tool that has less damaging consequences for your credit score. How much your debt settlement will impact your credit score will depend on the details of your settlement. You can attempt to do your debt settlement yourself or use a credit counseling company that will help you navigate your way out of your debts while impacting your credit score as little as possible.

It’s also important to remember that while your debt settlement will negatively impact your credit score in the short-term, the longer you wait to do something about your debt, the more you are damaging your credit score in the long-term.

How Does Debt Settlement Work?

Debt settlement programs are designed for Canadians who need help managing their debts and can’t afford to make the monthly payments on their debts. Debt settlement companies (also called credit counseling companies) usually administer a debt settlement program, and the aim is to convince your creditors to settle your debts for less than what is currently owed. If you have any cash available on hand, you can offer to pay off your creditors right away for less than the loan amount, or your credit counselor can negotiate new terms with your lender as part of a debt management plan.

Is It Better to Pay Off or Settle a Debt?

While it may seem tempting to try and negotiate a debt settlement for less than the original loan amount, keep in mind that this strategy will negatively impact your credit score. A debt that has been settled will be noted on your credit report, which is a red flag for lenders. For this reason, if you have the funds, it’s always better to try to pay off debt rather than to negotiate a settlement. That said, if the alternative to settling is not paying at all, then settling is preferable.

Which Type of Debts Should I Try to Settle?

When it comes to choosing which debts to settle, your credit counselor will adopt a triage mindset. That means they will attempt to settle the most overdue debts first, since these debts impact your credit score the most, and you may be punished with excessive fees or interest charges. On the other hand, if you have debts still in good standing, your credit counselor may determine that you do not need to include those debts in your settlement since debts in good standing will help you maintain your credit score.

Can I Negotiate a Debt Settlement by Myself?

While debt settlement is a service that credit counseling companies in Canada offer, you can attempt to do it yourself. You’re less likely to be successful, but you’ll also save on the fees that these companies charge for negotiating on your behalf.

If you are planning to go the DIY route, you will most likely be able to negotiate with your lenders to reduce your interest rate and extend your loan term, which will make your payments more affordable. You may also be able to arrange a partial payment.

To negotiate your debts, you’ll need to look at your finances and determine what you can reasonably pay towards your debts. Your budget will need to be highly accurate since you’re committing to making these monthly payments after negotiating with your lender.

Next, document the circumstances that led you to see a debt settlement. For example, if you experienced a financial catastrophe, gather documentation like bills and statements that you can show your lender to prove financial hardship.

Next, be prepared for your creditor not to be receptive to your request. You should get familiar with the laws about what they are and are not allowed to do to collect on their debts and prepare your offer in advance. If your creditor agrees to settle your debt, request all documentation in writing. Then, and this is very important, hold up your end of the agreement. Avoid late payments at all costs.

What Affects Your Credit Score More: Debt Relief or Bankruptcy?

Debt settlement will lower your credit score, but not nearly as much as a bankruptcy. Bankruptcy is a legal proceeding that will cause your credit score to drop dramatically, and it will also remain on your credit report for up to seven years. After bankruptcy, you may struggle to qualify for credit for up to seven years, even if you’ve rebuilt your credit during that time.

After a Debt Settlement, How Do I Rebuild My Credit?

After you’ve settled your debt, you’ll either be debt-free or on a payment plan with your credit counseling company or your creditors. Whatever your position, now is the time to make a fresh start financially and focus on building good money habits that will help you rebuild your credit score, set you up for success, and ensure you don’t end up back in debt.

Pay Your Bills on Time

When rebuilding your credit, it’s essential to pay all of your bills on time, not just your credit products. Paying your bills on time is important because a significant portion of your credit score is determined by whether you faithfully pay bills, even cell phone bills and utility bills.

Create a Budget and Financial Plan

If you work with a credit counseling company, they should be able to guide you on creating an accurate budget that allows you to pay off your remaining debts while still saving money and paying all of your other bills. A budget is essential because it enables you to track what you are spending and know right away if you are spending more than you earn. Overspending can lead to late payments, which will further damage your credit score. A financial plan will also help you set goals for your future, including saving for retirement and emergencies.

Be Mindful of Credit Utilization

Your credit utilization ratio is how much debt you carry on a revolving credit tool (like a credit card) as a percentage of your total credit limit. For example, if you have a credit card with a limit of $1,000 and you have a $300 balance, your credit utilization ratio is 30%. As a golden rule, it’s wise to keep your credit utilization ratio at 30% or less to rebuild your credit.

Consider Using a Secured Credit Card

After your debt settlement, your credit score may have dropped so much that you will have trouble qualifying for traditional credit tools like credit cards and personal loans. In that case, consider applying for a secured credit card to help rebuild your credit. A secured credit card requires a cash deposit equal to your credit limit to “secure” the card. You can use a secured credit card just like a regular credit card, and you’ll get your deposit back when you close the account.

How Long Does a Debt Settlement Stay on Your Credit Report?

While your debt settlement program isn’t as bad for your credit score as bankruptcy, it will appear on your credit report and stay there for about six years. Other information also stays on your credit report, including late payments, delinquencies, and bankruptcies.

Is Debt Settlement Really Worth It?

If you’ve found yourself with an unmanageable amount of debt, the worst thing you can do is ignore it. If you can’t manage your debt yourself, a debt settlement is an excellent option to help you get out of debt and start fresh and is better for your financial health than bankruptcy. While going through debt settlement will lower your credit score, the alternative of consistently missing payments or even defaulting on your debts is worse for your credit score overall.

That said, debt settlement is only a good tool if you make the most of it, and that means making every debt payment during and after your settlement, maintaining a budget, and being careful about not getting yourself back into debt.