If you have been struggling to keep up with your debt repayments and are considering a debt settlement to improve your financial situation, you should understand the potential affects to your FICO credit score.

What is a Debt Settlement?

A debt settlement allows you to pay less than the total amount owed on an account. This will help you get out of debt faster and make it possible to keep up with your living expenses. Typically with a debt settlement, if a creditor agrees to ‘settle’ and accept less than owed, you need to have the amount ready to send in a lump sum. Once the amount is sent, the account should then be closed and no further action can be taken from the creditor to collect the remaining amount of the debt.

What About Your Credit Score?

If you’re considering a debt settlement, chances are good that you’ve already experienced a drop in your credit score. Only people who are having extreme difficulty keeping up with their payments and living expenses should even consider a debt settlement. While it’s better than filing for bankruptcy, a debt settlement will be reported to the credit bureaus, show up on your credit report as a negative notation, and will cause your credit score to drop considerably – by as much as 125 points.

Debt settlements remain on your credit report for 7 years after the original delinquency date of the debt. You will have trouble obtaining credit while this remains on your report.

On the plus side, however, if a settlement makes it possible for you to begin paying your other debts and expenses on time, every time, where as you couldn’t before the settlement, you can quickly begin increasing your credit score by making on time payments on the remaining debts you still have after the settlement.

Debt Settlement and Income Taxes

What many people don’t realize is that debt settlements may also affect your income taxes. When you file your income taxes after a debt settlement, you are required to pay income tax on the difference between what you owed and what you actually paid as “income”, with a few exceptions to the rule. If you owed $16,000 but settled the debt for $8,000 – at income tax time you have to report the other $8,000 as income and pay taxes on that amount unless you meet criteria for the exceptions. This is something you will want to look into before agreeing to settle your debts.