If you’re thinking about settling your debt, or in the process of doing so, you’re probably looking forward to having that financial weight taken off your shoulders. You might also hope that your credit score will rebound quickly once you settle your debts. Debt settlement, though, won’t improve your credit score right away, and in fact, will likely cause your credit score to drop. Here’s what you can do to rebuild credit after debt settlement.
Related article: How to settle debt and remove it from your credit report
There’s a good chance your credit score is already low from missing months worth of debt payments. The good news? Once your debts are settled, much of rebuilding your credit will rest in your hands. Using credit responsibly, especially paying your bills on time, will help you rebuild your credit history. Still, you should go in knowing that it will take some time.
How debt settlement affects your credit score
The reason debt settlement is considered a negative mark on your credit report is because settled debts are those that you’ve paid off for less than what you owed. Which means you didn’t pay the debt in full or as agreed. In most cases, it’s better to settle a debt than to continue to miss payments, but it will still ding your score.
If possible, it’s best to settle your debts before they are charged off. A charge-off is when a lender “writes off” a debt after 180 days of not receiving a minimum payment from you on the debt. However, you still owe the debt and it will still appear on your credit report. This is also the point where a lender might sell the debt to a third-party debt collector.
When a lender writes off your debt, they close your account and list it as a charge off, which hurts your credit score. For many people, though, it can be tough to both negotiate and come up with the money to settle several debts within a six-month time frame. So you might want to settle one card and target one that you can take care of before a charge off happens.
Related article: What does it mean to have my unpaid debt charged off?
The debt settlement process will especially hurt your credit score if you’ve stopped paying your creditors to save up money to settle your debts. That’s often what a debt settlement company will ask you to do if they’re negotiating on your behalf.
How long does debt settlement stay on your credit report?
When you pay off an account, your creditor updates your account to reflect the new status (closed or paid in full, for example). Debt settlement is the same: After you settle a debt for less than what you owe, the account will be designated settled.
If you have no history of late payments, aka “delinquencies,” the account will remain on your credit report for seven years from the date the account was settled. Or if you did fall behind on your payments, the account will stay on your credit report seven years from when it first became delinquent and was never current again. But you can start improving your credit score before those debts disappear from your report. And the older those debts get, the less they’ll hurt your score.
How is my credit score calculated?
When considering how debt settlement affects your credit score, first it’s helpful to understand the factors involved, and how each is weighed. There are three main consumer credit reporting bureaus — Experian, Equifax and TransUnion — and each have their own credit scoring methodology similar to the original FICO credit scoring model created in the 1950s. Here we’ll focus on the traditional scoring model, which is made up of five different categories, each weighing differently on your final credit score:
1. Payment history: 35%
The payments you’ve made on things like credit cards, your auto loan and even student loans make up your payment history. If you’ve never made a late payment, chances are your payment history is giving your credit scores a nice boost. Late payments, though, especially those that are 90-or-more days late, can really ding your scores.
2. Credit utilization: 30%
Credit utilization measures how much of your available credit you’re actually using. For example, if you have a credit card with a $12,000 line of credit and you’ve charged $9,000 in purchases recently, that means your credit utilization on that one card is 75%. That kind of ratio is going to have a negative impact on your credit scores. It’s best to keep your credit utilization below 30% if possible.
3. Length of credit history: 15%
This is just what it sounds like — a measure of how long you’ve had credit accounts in your name. Fortunately, your length of credit history accounts for just 15% of your score, but it can be frustrating if it’s routinely dragging down your scores, even just a little. Some people without a credit history or a “thin” credit profile start with secured credit cards to help them get started.
4. New credit: 10%
Unlike length of credit history, this category does help younger consumers looking to improve their credit. That doesn’t mean you should run out and apply for every type of credit you can find. Taking out too many lines of credit in a short period of time can actually have a negative effect on your credit scores.
5. Credit mix: 10%
The types of credit accounts you have can be important to your credit scores, because lenders like to see that you’ve been able to handle different kinds of revolving credit and loans.
How long does it take to improve your credit score after debt settlement?
The amount of time it takes for your credit to start improving will largely depend on your credit history. If those settled debts are somewhat of an anomaly for you — you’ve successfully paid off several debts in the past — that will help your credit rebound. That shows lenders you are capable of paying your debts on time. Having other debt you’re still paying and are current on, such as a mortgage, car loan or other credit accounts will help, too. People with a fairly robust and positive credit history might be able to start improving their credit score in six months or possibly as little as half that time.
If your credit history is skimpier, it could take much longer. For example, if you don’t have a history of paying off debt and you aren’t currently making timely payments on a mortgage, a loan or other credit cards. And if the accounts you settled were ones you’ve had for a long time, it could hurt your score because the length of your credit history (including the age of your oldest account) makes up 15% of your credit score. If you have a poor and/or thin credit history, it could take 12 to 24 months from the time you settled your last debt for your credit score to recover.
Either way, you’ll benefit from debt settlement if that means you’re no longer missing payments. It will also improve your debt-to-income (DTI) ratio, the amount of monthly debt payments you have compared to your monthly gross income, and your credit utilization, which is how much credit you have available versus how much you’re using. Lenders look at your DTI in the loan approval process and your credit utilization makes up 30% of your credit score.
“With the current risk-averse lending environment, creditors are less likely to underwrite new loan products to someone who has a debt-to-income ratio out of line with their set parameters,” says Michael Bovee, debt expert and co-founder of Resolve. “This fact is affecting the ability of many people who want to get new credit – even those with a good credit score.”
How to rebuild your credit after debt settlement
The best thing you can do to build up your credit score is to pay your bills on time. Your payment history makes up the biggest slice of your credit score at 35%t. The next best thing you can do is to keep your credit balances low, to keep a good credit utilization balance.
If you still have open accounts, such as a mortgage or credit card, make your payments on time. If, after settling your debts, you don’t have many or any credit accounts left, you might consider asking a trusted friend or family member with good credit history to become an authorized user on one of their longer established credit cards. That will help you start rebuilding your credit history faster.
Related article: 5 steps to rebuild credit after debt settlement
How Resolve can help
If you’re dealing with debt and not sure what to do, we’re here to help. Become a Resolve member and we’ll contact your creditors to get you the best offers for your financial situation. Our debt experts will answer your questions and guide you along the way. And our platform offers powerful budgeting tools, credit score insights and more. Join today.