Each one of these 3 credit solutions can be a viable solution for getting out of debt, depending on the circumstances you’re in and the resources you have available.
Any one of these can get you out of debt when used properly, but each has very different effects on your wallet and your credit report:
- Debt Settlement – This is when you negotiate with creditors to pay less than you owe on a debt. Often, the settlement is a one-time payment or series of payments that requires months — sometimes, even years — to accumulate. There are some serious negative consequences to this option.
- Debt Consolidation – This process involves combining all debts and taking out one loan to repay them. A single payment replaces multiple payments to multiple creditors. It’s possible the monthly payments and interest rate will go down, but it’s also probable the payoff will take longer and have an impact on your credit score.
- Bankruptcy – This is the last resort for someone who has met a severe and unexpected circumstance (such as job loss or medical bills) and is unable to pay outstanding debts. Bankruptcy allows you to wipe out all unsecured debt, but your credit history will be damaged for up to 10 years.
Credit solutions affect your credit reports and credit scores differently. These effects may not be entirely predictable, since they rely on your unique situation —how long your credit history is, your payment history, your use of available credit and other factors.
It is wise to consider all your relief options and seek the advice of a qualified credit counselor from a non-profit organization before making a final decision. Remember that there are pros and cons associated with each choice. Make sure you are comfortable with the conditions and time frame involved in carrying out debt settlement, debt consolidation or bankruptcy before pursuing one of the choices.
Debt Settlement and Your Credit
Debt settlement is an enticing, but sometimes risky method of paying off debt. The chance to pay off a debt for half of what you owe — or maybe even less — is very appealing, but it comes with the understanding that your credit history and your credit score will take a severe hit for seven years.
If you have or expect to have the resources to make an offer to settle your debt — and don’t really care about your credit score — this is a viable option.
The problem is that the process usually includes an extended period of time during which the consumer makes no payments to the creditors. Instead, money is put aside for the offer to settle the debt. Not making payments has a very unfavorable impact on your credit score. Any settlement reached will be for less than what was owed and that too, is viewed as a negative.
How bad a hit your score takes depends on your credit history. A debt settlement remains on your credit report for seven years, but its effect diminishes over time. If you can make regular, timely payments to your other accounts, you eventually can improve your credit score over time.
Debt Consolidation and Your Credit
Debt consolidation is a tool to help you get back on track with your finances. A debt consolidation loan allows you to pay off multiple bills and focus in one direction. You still owe the same amount of money, but now you have one payment per month, hopefully at a lower interest rate.
The country’s 3 major credit bureaus respect the effort to get your finances under control. According to Experian, one of those three, debt consolidation’s impact on your credit scores will be minimal, as long as steady payments are made on time. If, however, you are late with payments, expect your score to drop.
The same is true if you use a Debt Management Program (DMP) as the method for consolidating bills. A DMP calls for monthly payments to all creditors. If regular payments are being made on time, the credit bureaus will respond positively. DMPs usually ask you to close all but one credit card account, which will have a temporary negative effect on your score, but the effect of regular payments over time will turn that into a positive.
As time goes on, your credit score should start to climb.
Bankruptcy and Your Credit
Bankruptcy is a workable solution for debt problems when you run into a crippling financial situation like job loss, unexpected medical bills or unpredictable changes in real estate or stock market investments.
If one or some combination of those unfortunate circumstances happens, and you know you can’t afford the bills you owe, bankruptcy gives you a second chance. That is why the law exists.
While you might be able to walk away from your unsecured debts, you will not be able to walk away from the negative impact bankruptcy has on your credit score. Consumers with a high credit score could see their scores drop by 200–300 points, sliding them into the “poor credit” category. Consumers with average or low credit scores could lose 100 points, which also could drop them into the “poor credit” category.
There are two types of consumer bankruptcy – Chapter 7 and Chapter 13 – and each brings its own impact to your credit score.
A Chapter 7 bankruptcy is for the discharge of all unsecured debts such as credit cards and medical bills. This does not include student loans, which can’t be discharged in bankruptcy.
Chapter 7 stays on your credit report for 10 years, but the major debts associated with it — usually credit card and medical debt — are discharged after 7 years. These negatives will have less impact on your score as time goes on, which is why if bankruptcy is inevitable, it makes sense to file quickly rather than allowing debts to linger in collection accounts.
A Chapter 13 bankruptcy is designed to give the consumer time to work out of debt, usually 3–5 years. Notice of filing Chapter 13 bankruptcy stays on your credit report for 7 years, even if you have paid off all debts in the 3- to 5-year window. Another issue is that discharged debts remain on your credit report for 7 years after they are discharged. In most cases, that means they will still be on your credit report — even after you have completed Chapter 13 bankruptcy.
There are ways to begin rebuilding your credit score quickly after filing for bankruptcy. Getting a secured credit card is the first step. Getting approved for a retail or gas credit card or taking out an auto loan are also good steps. They will not restore your status immediately, but will help you regain some of the ground you lost.
Effects of Credit Solutions on Your Credit Score
The Fair Isaac Corporation (or FICO) credit score is used in 90% of lending decisions in the United States. FICO published a list that details what effect certain events will have on your credit score.
It is worth noting that consumers with high credit scores usually take a bigger hit to their credit score than those with lower scores.
|Issue||If Your Score is Around 680||If Your Score is Around 780|
|30-day late payment||Down 60-80 points||Down 90-110 points|
|Debt Settlement||Down 45-65 points||Down 105-125 points|
|Bankruptcy||Down 130-150 points||Down 220-240 points|
Tips for Resolving Debt
If you’re working to pay off your loans, keep these basic tips in mind:
- Create a budget, and stick to it. List all your income and all your expenses, and then decide whether your income could be used more effectively.
- Contact creditors if you find you cannot meet your payments. You may be able to arrange a modified payment plan.
- Work out your total debt. List how much you owe, along with interest rates and minimum payments. This will help you plan and prioritize your spending.
- Create a repayment plan, and set a target date for when you can expect to finish paying off your debt.
- Do not take on additional debt. Paying off one debt will not help if you accumulate other debts.
- Identify those debts with the highest interest rates, and pay off those first.
In considering your financial options, remember that your actions today can stay with you for years. Seek the help of a credit counselor if you are unsure of what step to take next.
Once you’ve chosen a path, follow through on the plan and get out of debt. After that, update your budget and stick to it. A good budget makes it much easier to stay debt-free.
About The Author
Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].
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