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How Debt Settlements With Creditors Affect Credit

Written by Hank Coleman

If you’ve made poor credit decisions, experienced a financial disaster, or ran up a large amount of credit card debt in the past, then you might be familiar with debt settlement. There are many third-party companies that can help consumers settle their debt for pennies on the dollar. But, like most things, setting your debts has consequences.

A debt settlement is the process of negotiating a payoff with your creditor for less than the amount you actually owe. For example, if you owe a credit card issuer $10,000 on a Visa or MasterCard and the company agree to accept only $5,000 instead as payment in full for your debt, you’ve just settled the account.

You can settle debts with your credit card company and other lenders on your own. Or, you can hire a firm that specializes in debt settlement to handle the process for you. In addition to the company’s fees, you typically pay the debt settlement company one set payment each month, and they pay your monthly debts for you according to a repayment plan.

Using a debt settlement company allows you to make only one payment, and it may reduce the total annual interest rate that you pay on the debt. Or, you may be able to negotiate debt settlements yourself with your individual lenders.

What is a debt settlement?

With debt settlement, consumers are often able to reduce their overall debt and pay only a portion of what is actually owed to their creditor. When the consumer pays the agreed upon settlement, the lender will typically update the account on the consumer’s credit report to reflect a balance of zero dollars.

However, in addition to the zero balance, a notation is also usually added to your credit report which reads something like “settlement accepted on this account,” “partial payment plan,” or “settled for less than the full amount.”

Debt settlements are considered to be derogatory events by the credit bureaus and the FICO and VantageScore’s scoring systems. Debt settlements have the potential to inflict a large amount of damage to your credit scores, and they remain on your reports for seven years.

Why debt settlements are derogatory

There’s a lot of misinformation floating around the Internet regarding debt settlement. First, it’s important to understand that a settlement indicates a failure by the debtor to live up to their end of the lender/borrower agreement. Your credit score will take a hit by settling an account.

Events leading up to a settlement typically weigh on your credit score too. If you need to settle a debt, you’re most like having trouble paying your bills and debts. You may have missed a payment. You may have paid less than the minimum monthly payment to get by for a little while. Each of these events negatively impacts your credit score, and you lender reports these missed payments each month.

And, if one of your accounts is already in default, and being reported as such, then the account is already having a negative impact on your credit scores. But, settling the debt will cause more damage to your credit report. It might be minor at that point, but it will still impact your credit score nevertheless.

Upsides to debt settlements

Settlements certainly have their downsides. But, they can also have a pretty appealing upside as well. If your debts have already been sold to collection agencies and have turned into collection accounts, then settlements are likely a very smart option. But, you will probably have to settle with the collection agency instead of your actual lender though.

Here are a few reasons why settling your debt might be a great financial move:

  1. Settlements save you money

If the account you’re settling is in collections, you should keep in mind that the collection agency or debt buyer purchased your original debt for pennies on the dollar. Despite the fact that you defaulted on potentially thousands of dollars with the original creditor, the collection agency didn’t pay your lender the actual default amount you owed when they bought your debt.

When you settle an account with a collection agency for less than the full balance, you are saving yourself money and helping the collection agency to make a big profit. In this case, settlement can be a big win for everyone involved.

  1. Settlements stop collection attempts

When a creditor or collection agency agrees to accept a settlement on your defaulted debt, they must also agree to stop pursuing you for the remaining, unpaid balance of the debt. Settling an account can help you say goodbye to annoying collection calls and letters. When you settle a collection account, it may also protect you from the possibility of being sued.

  1. Peace of mind

Settling your debt will most likely give you peace of mind. It will be another thing that you can put in the past and move on from in your life. It can be a new lease on life.

Make sure its reported to the credit bureau

After you agree to a debt settlement, you’ll want to make sure that the lender, collection agency, or debt settlement company reports the repayment to all three credit bureaus and the Fair Isaac Corporation that runs the FICO credit score. Sometimes, the credit bureaus or your lenders overlook updating your account.

It might show that the account is in collections. But, you’ll still want to ensure that it shows the account is closed and paid. It will hurt your credit score no matter what, but having an error on your credit history will continue to hurt years afterward if you do not stay on top of it. It’s better to ensure that the credit report is accurate now than fight with the credit bureaus years later.

Get it in writing

You must ensure that you get it in writing that your agreed upon payment of less than what you owe on the debt is considered payment in full. Do not take someone’s word over the phone that it will settle the debt in full. Get it in writing before you write a big check. You don’t want your creditors or a collection agency coming back after you for the balance later.

You’ll owe the IRS

Here’s the real kick in the pants after you debt settlement is all said and done. The United States Internal Revenue Service (IRS) looks at the forgiveness of loans as income. In essence, the lender gave you money to forgive a portion of your debts. You’ll owe taxes on that income even though you didn’t see a dime of it physically in your bank account.

If a portion of your debt is canceled or forgiven, you must include the amount that was forgiven in your gross income figures when you file your income taxes at the end of the year. If the amount is over $600, the lender or collection agency will provide you with a 1099-C form and also send a copy to the IRS.

Debt and its forgiveness seem to be another gift that keeps on giving. So, plan now how you are going to pay taxes on that increase in income at the end of the year.

A debt settlement is not for everyone. There are consequences to paying less than you owe to your lenders that will follow you for years. But, settling your debt can help you recover from poor credit decisions. It can help you begin to turn your life around after a financial disaster.

About the author

Hank Coleman

Hank Coleman is the publisher or the popular personal finance blog, Money Q&A. He’s also a freelance journalist specializing in retirement planning, investing, and personal finance. You can also find him on Twitter @MoneyQandA.


  • I live in California where the statute of limitations is four years. Last time I paid on a credit card was four years and two months ago. Does that mean the statute of limitations has run out on these cards? Is there another starting point for the statute of limitations?

  • I ran a major credit and collections firm for more than 25 years. Debt settlement does nothing to improve your score. These days, paying off debt has become more of a moral issue than a legal one. Just demand that all further contact cease and desist, and document that request; any licensed collection agency will abide by that request. Statistically, there is only a 1-2% chance a collection agency will sue, and then, only if the amount if high enough (typical bank cards need to be at least $5,000). Going to a CRO won’t prevent them from suing, if they really want to. And don’t worry about the 1099-C. IRS Form 982 will discharge you from any financial obligation, if your net worth is less than the reported 1099-C debt. Finally, keep your money in your pocket; your family will need it when you use your debit card or pay cash.

    • Hooray for IRS Form 982. I used it a few filings back when I unexpectedly got “gifted” with a 1099-C on December 31. What timing. Coincidence? I think not. It took me hours of research to find this form but my mantra was: Rich people do not pay these penalties, therefore, there must be a form. That was also the first and only year I hired a tax professional to do my taxes. He looked at me and asked me why as I had already done it all correctly. I replied: peace of mind. If I’m going up against the IRS I want a major company to be my front man!

  • I read all the questions and replies but didn’t find the following: What if 4 out of 15 creditors do not want to grant you the settlement offer? What happens then?
    Next question: I’ve been contacted by many companies but am not sure which one to choose or if It’s be even worth it to go into that route as I have no delinquent account and 100% payment on time record and about 50K in debts; do you have any particular company you’d recommend based on your blog’s participants experience? Please advise. Thank you

  • I have a payment arrangement with a collection agency.did not ask for a settlement letter.Is it too late.have had this arrangement for 3 months and have payment made directly from my checking account.

  • Hello Abbey, I have a $200 dental bill collecton on my credit. I contacted the dentist directly and they agreed to settle for $180 in 2 weeks. Since making that agreement I’ve learned that I should now be sure to get everything in writing and try to request a “pay for delete “. I’m now curious though…should I be contacting the collection agency directly to have them do this or can the dentist actually do this if I pay ot to them directly? Which would be sure to affect my credit with the most positive outcome?
    Thank you in advance for your advice!! 🙂

  • Hi Abbey, I desperately want to improve my credit score. I understand that the fastest way to do that is by using secured credit cards. It seems like there are millions of them out there. Can you suggest a few good ones that will do the trick? Thanks in advance.

  • One other thing about collection agencies…they are not your friend, they are your adversary, no matter what they say or do. The only way they get paid is to get money from you. Period. Lying and trickery is part of the game. If you want to deal with these individuals, and you agree to send money…DO NOT send a personal check, or even worse, authorize an electronic transfer. Once they have your account info, you have lost all control of your money. Ideally, a money order, or even better, a certified or cashier’s check is the only way to give them money. It is a headache to get, and it may cost you a buck or two, but you still control your own money!

    • Hi Pat,

      You make an excellent point about being in control of how your funds are transferred to a debt collector. Have you had experience with this in the past that you can share?


  • Here’s the problem I ran into: I tried to settle a debt and the collection agency refused to give me a “deletion for payment” letter. I decided not to pay the debt as there was no advantage for me to do so. The date of last activity was over 3 years ago. However, the collection company is now listing my debt as having delinquent payments using the current month… in essence “re-aging” the debt. Is this legal?

    • Hi Diana,

      “Re-Aging” occurs when a debt collector extends the “purge from” date of your debt (the date it is automatically removed from your report, generally 7 years from the date it was first sent to collections). If you haven’t paid this debt and it is still within the 7-year timeline, they are within their rights to continue to report it to the credit bureaus. If they have changed the purge from date, then they are violating the law and you should dispute this error.

      You can learn more about re-aging debts here:


  • With the statute of limitations, is it from the original borrowed date, last payment date, or sold date to a collector?

    • Hi Jake,

      Generally, the statute of limitations “clock” starts ticking from the date that the first payment was due. However, these restrictions vary form state to state and depending on the type of account, so it is best to check with your state attorney general’s office to determine what the rules are for where you live.


  • Hi.
    What about if I completed a settlement almost 5 years ago but didn’t know about the deletion letter?. I completed the settlement with a collection agency and have all the papers (there was a second mortgage). Can I have the opportunity to make an arrangement with them for a deletion?.

    • Hi Blanca,

      You can certainly try to ask for a deletion, however since this is not their standard practice and this account was paid so long ago, I wouldn’t count on them granting your request.

      This item will fall off of your report after the 7-year mark, but in the meantime you can try disputing the item with the credit bureaus themselves. If you request verification of the debt in writing, they will request this information from the original creditor. If the creditor does not provide this information within 30 days, then they are required by law to delete the item from your report.

      You can learn more about this and get some sample letters here:


  • I had a credit card over 10 years ago. I got sick and fell behind. The same credit card company send me another card in which I always paid on time. To make it short, I paid my bills over the phone or online, the person credit the wrong account with the payment and next thing you know it . My bank account was frozen. I travel alot working so I never received any letter from Household bank that I was being sued and had a court date, you know why because I wasn’t home. They said someone signed the notice who didn’t live there. To make it short, my bank froze my accounts and they took the balance which they said was 1800 for a 300.00 limit credit card. The account was over 15 years old

  • The article should mention that, when negotiating for a settlement, you should ALWAYS ALWAYS insist on a letter from the collector, that specifies the details of the settlement prior to you actually giving them money. They are notorious about not sending those letters once they get a payment !! And another thing…if possible and really try to get this, is a “deletion for payment” letter. The collector can send you a letter that says they will will delete the debt from your credit report if they receive your payment, which is better than a “settled for less” on your acct. They don’t like to give those deletion letters but they can ! If you pay them a little “extra” they might do it. I always try extra hard to get them to accept a little more money and in exchange I get my deletion letter.

  • Is it possible to go directly to the original company and settle the debt and not go to the 2nd party collection agency?

    • Hello,

      It may be possible to negotiate directly with the original creditor, if they still own your debt. When a creditor has not received payment for 6 months, they typically assign the debt to a third party company to collect it, or they sell the debt to them entirely.

      If your creditor has sold your debt, then you will likely have to deal only with the agency that they sold it to. It makes sense–they bought your debt and will only get a return on their investment if any payments you make go to them, not to your original creditor.

      If your creditor still owns your debt, you have a better chance of being able to negotiate with them directly. Contact your creditor directly and ask about negotiating a payment with them, either in a lump sum or a payment plan that you can realistically follow. Make sure you don’t send any funds until you have the terms in writing.

      Good luck!


  • Please don’t forget, that when you settle your account for a reduced amount, you will have to report the difference on your tax return. The company will send you a 1099C for the amount that was not paid. Depending on you fincinancial situation you may have to pay tax on the balance. However there is a insolvency worksheet that you can fill out to see if you really have to pay the additional tax.

  • Understand you may need to pay income tax on the settled amount. The IRS considers the unpaid amount INCOME and you should receive a 1099-C from the settlement company. Unless you are insolvent or declare bankruptcy or the settlement was for a mortgage – you owe more than you are worth. Settlement companies have a habit of saying don’t worry most people qualify for insolvency — NOT TRUE if you have a 401K or own a car or anything — home electronics, computers, furniture, lawn mower, furnishings etc….

    It is still worth it in the end but don’t underestimate the IRS tax implications could be HUGE

  • Please keep in mind all debt settled for eg: you owe $9000 you settle for $5500
    On your taxes you now have an additional income of $3500 to claim and pay tax on.
    I learned this the hard way
    Good luck to All !!!

  • When you settle a debt, for instance pay 5000 on a 10000 debt, does the 5k difference get reported as income to the IRS and you have to pay tax on it ?

  • The only time I make a settlement with the collection agencys I tell them I will only pay them after they send me a letter stating they will remove it from my credit report if when IRS paid. Other than that its not worth it.

  • I have received a settlement collection notice. My question is this, this item no longer shows up on my credit report. What should I do???The offer is half of $135.00 the 67.50 can be made in 2 payments of $33.75. Would it be wise to ignore it or to go ahead and settle it??? Like I said Sprint no longer on my credit report??? What do you advise?
    Thank you,

    • Hi Debi,

      Whether or not you pay this debt is up to you. There are a few things to consider:

      (1) You still owe this debt, and Sprint (or the collection agency they are using) is still within their rights to try to collect it. They can keep contacting you to try to solicit payment.
      (2) Since the item is no longer on your credit report, it no longer affects your credit score.
      (3) Depending on your state, this may still be within the statute of limitations. If it is, then they can legally take legal action against you. You can find out more about your state’s statute of limitations by checking with your state’s attorney general office.


  • You failed to mention though, that settling a debt for less than the balance whose forgiven amount is $600 or more will require the company to send a report of such to the IRS and to send you a copy of that statement. You will have to report that forgiven amount on your income tax return and have that amount also subject to a tax amount. Those companies do tell you that, since they are required to.

  • If after 7 years the debt is taken off my credit report and sold to a collection agency, what is my obligation to the collection agency?

    • Hi Richard,

      That collection agency owns your debt and is within its rights to attempt to collect it for as long as they can. They cannot put the account back on your credit report, and if the statute of limitations has expired they cannot take you to court over it. You do still owe the money and have an obligation to pay it to the collection agency.

  • When settling a debt, do they ever agree to report the debt is paid as agreed or paid in full? Would that not be a positive on the report.

  • What if the debt is over 7years old ? I know the statues of limitations in my state of Nevada is 4 years. So legally they can’t sue me for the debt right ? So what should I do?

    • Hi Sharlene,

      If the statute of limitations has expired on this debt, then the debt collector cannot take legal action against you for it. That’s good news–you won’t ever be dragged into court over this debt. However, you still owe the debt and the debt collector can still try to collect it for as long as they want to put forth the effort. The account can still show up as a negative item on your credit report for 7 years from the date it went into collections, but after that time period has lapsed it should fall off your report for good.

      Keeping these facts in mind, you may or may not want to negotiate a settlement with the debt collection company. Yes, you will never be sued over this debt, but are you OK receiving calls about it years from now? How you handle the situation is really up to you.


  • How do you handle pay day defaulted loans is it good to hire pay day loan consolidation if you have 5 or start paying slowly one at a time on your own

    • Hi Kay,

      One of the worst things you can do when trying to get out of debt is create more debt. There are reputable debt consolidation companies, but many are as predatory as the payday loan lenders themselves. If you are able to cut your expenses short-term to pay off these loans, the sooner you can get rid of them the better. It may also be worthwhile to try to negotiate a payment plan or settlement with the payday loan provider if they are willing to work with you. You can also read more about alternatives to payday loans so that you can avoid them in the future:


  • Hi,

    Can most debt collectors delete the debt after you pay them??

    We are buying a house and two debts for a cell phone came out of no where ended up on my husbands credit. Our lender stated to pay it and ask them to delete it.

    • Hi B’onca,

      It sounds like you are talking about something called “pay for delete”–this is when, as part of the debt settlement, a debt collector agrees to have the account removed from your credit report in exchange for your payment. There is no official “pay for delete” program, and in fact the credit bureaus frown upon this practice. That being said, many people have reported that this tactic works, however I wouldn’t count on it as a definite possibility. If a debt collector agrees to do this for you, make sure that it is included in the settlement letter before you send in any payment so that you have a written record of their obligations.


  • If you account has been written off by the original debtor and another collection agency picks up the account and wants to settle will making an arrangement change want the debtor has on your credit “written off”? I know both are negative on your report

    • Hi Anna,

      If I understand you correctly, you are asking if settling a debt with a collection agency will remove the “charge-off” on your credit report from the original creditor.

      Although collection agencies have been known to agree to remove a collection item from your credit report in exchange for payment (sometimes this is referred to as “pay for delete”), this is not the norm and you should not count on them doing this for you. The same goes for the original creditor. Whatever you agree to in a debt settlement negotiation, make sure that you receive all of the terms in writing before you make any payments.


    • Hi Patty,

      When a debt is settled for less than the total amount, the unpaid amount is considered “cancelled debt.” The money that would have been used to pay this debt is now free to be used for anything the taxpayer wants. The law defines “income” as accession to wealth that the taxpayer has complete control over (basically getting access to money that you can do whatever you want with). Since cancelled debt falls into this category, it is considered income and is taxable.


  • I have received a collection notice on an unpaid Sprint bill that no longer shows up on my credit report. Since it’s a collection notice requesting settlement at half the amount owed to be made in two payments would it be wise to settle this account??? How will it effect my credit report???
    Thank you,

    • Hi Debi,

      Since the account is no longer showing up on your credit report, paying it will have no affect on your credit score. As far as whether or not you should pay the settlement amount with the company, that is completely up to you and how you feel about having outstanding debt.

      First, you should consider the statute of limitations–if it has not expired on this debt, then you are still at risk for being sued and possible having a judgment against you. You can check with your state’s attorney general’s office to find out what the statute of limitation is where you live.

      Second, consider that even if the statute of limitations has expired and the item has dropped off your credit report, you still owe the debt and the debt collectors can still try to collect it.This means that you could receive calls from collection agencies indefinitely. Depending on the amount you owe, paying it may be worth the peace of mind you would receive in return.


  • JuSt be careful, because they then issue you s 1099 and cause you to pay interest on the amount that you didn’t pay. They consider it income!

  • Hi! If you forgo a “settlement” (in collections) and pay the entire amount owed, what notation will be made on the account and how will it affect my credit?

    Thanks in advance for your response.

    • Hi Sheri,

      If you pay off this account in full, your report will reflect that. The problem with collections accounts is that they are damaging to your credit report just by their being there, whether they are paid or not. You see, once a collections account starts showing up on your credit report, the brunt of the damage as already been done. Potential lenders care more about the fact that the account became delinquent in the first place than they do about whether or not you eventually paid it off. This is why debt settlement is a good option for many people. The simple answer is, paying off your debt alone will not greatly affect your credit score.

      Keep in mind that this does not mean that you should simply not pay down your delinquent accounts. By not paying, you are at risk for being sued, getting a judgment against you, or even wage garnishment. Settling or paying this debt in full will prevent these things from happening.


  • I just settled one in May and was told I would receive a letter of paid in full and here it is almost July and still have not received the letter. I do not have the information anymore as I set it up 6 months ago. What can I do?

    • Hi Linda,

      If you have not received a settlement letter or any agreement that lays out the terms of your debt settlement, you should refrain from sending in any payment until you do. You want to make sure that you have all of your ducks in a row with this company before you send in the final check.

      Follow up with the company, in writing if you can’t get anywhere on the phone. Keep records of all communication, and don’t assume anything that isn’t clearly spelled out in writing.


  • When you settle a debt with a collection agency for less than the full amount, you say “they must also agree to stop pursuing you for the remaining, unpaid amount of the debt.” Do they retain the right to SELL the balance you did not pay to another collection agency? Or does this end the debt?

    • Hi Mary,

      When you agree to settle a debt for less than the full amount, they should give you a written settlement agreement that lays out the terms. This is a contract between you and the debt collector that says that you will pay them X amount and the debt will be considered paid. As the article mentions, this will negatively affect your credit in the short term, but you will no longer have to worry about your debt being sold off to third party collection agencies.


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