Credit Score Impact of Settling Past-Due Accounts

Dear Opening Credits,

I'm 26 years old. I currently have a 583 credit score due to late and no payments -- the result of a layoff. I'm back on my feet now, and will be receiving a small settlement. I owe on four accounts. The first card has a balance of $500, the second at $2,000, the third at $4,200 and the fourth at $2,200 (student loan). Based on my credit score, is it smart to settle my debt?

- Frank

Dear Frank,

The answer depends on your ultimate goal. If saving money is most important to you, a debt settlement is the way to go. On the other hand, if you would rather increase your credit rating, paying in full is better.

Your credit score is already low, so a settlement won't ding it as drastically as if it were high. However, paying less than you actually owe is considered a negative event. It indicates that you did not adhere to the original agreement, which creditors tend to find quite disagreeable. After all, when they lend money, they want it back. Not a little bit of it. All of it. Therefore, since credit scores exist to help them make accurate decisions about their customers, credit scores take settlements into consideration -- and your numbers will decline if you choose that route.

Another angle to explore, though, is moral obligation. If you want to do the right thing, paying everyone back according to what you initially promised is best. I always encourage people to look beyond what they can get away with. Did you sign a contract that said that you'd pay your bills according to certain terms? If so and you have the ability to honor it, that's what you should do.

Still want to settle? You may be able to do that. First determine if the account is in collections. Most original creditors won't bargain the balance down, but collection agencies that assume delinquent accounts can be more amenable. The reason is that they bought the debt for a lot less than it is worth. For example, the agency might have purchased that $2,000 account for $1,000. If you settle for $1,500, they still come out ahead. Sure they'd like the entire amount, but they're often happy to not make all those annoying, resource-sucking phone calls.

To introduce the idea, call the creditor and explain what you're willing and able to do. Be reasonable. If the account just passed into collections, they may hold out for more than if it has been lingering for years (especially if it's past the statute of limitations and they can no longer sue you). When you've negotiated an amount, send a letter with a summary of what you discussed, explaining that you will send a check that will cover the debt. Be clear that the money you send is to settle the debt for less than the balance and that they can't come after you for the remainder. Send it all certified mail, return receipt requested. Keep copies of all correspondence.

If none of the accounts are in collections yet, you'll have to contact the financial institutions directly. Read "Card card debt negotiation in 3 (not) easy steps" to find out what you can do and, more importantly, what steps you'll need to take. It's also important to remember that you'll be socked with income taxes on the amount of the forgiven debt. The Internal Revenue Service considers that amount as income, and if it's more than $600, expect to receive a 1099-C form on which it must be reported.

Assuming the collection agency or the banks accept your offer, mail the check. Check your credit report in about 30 days. The account that you settled should read as such, but that it's now at a zero balance.

Mind that student loans are another story. If you've defaulted, you've got to get back on track, and settling isn't usually an option. Paying is. So contact the lender, collector or guaranty agency that's holding it and say that you're ready to rehabilitate your student loan. Ask what they'll accept as monthly payments. While it's possible to pay very little, arranging that can be a major pain in the neck, so take their lead and maximize the amount you send, as long as it's within your budget. Once the default notation is removed from your report (in just under a year), your credit scores should rise.

Finally, if you want to add positive information to your credit reports so your scores will spike faster, use any card that you still have open for small purchases, but pay in time and in full. It's that simple.