There are far too many myths floating around the world of consumer credit. The process and subsequent impact of settling derogatory debts with a debt settlement is no exception to that rule.
A debt settlement is the process where the debtor and the creditor agree on an amount that will satisfy the debt.
Although it has not been “paid in full,” the debt settlement allows for the creditor to be owed nothing more from the debtor.
This is when the myths tend to occur:
Myth #1: Settled debt is deleted from credit reports
Truth — Settled debt remains on a consumer’s credit report until it is required to be removed by federal law.
The Fair Credit Reporting Act, FCRA, governs virtually all things related to consumer credit including how long derogatory items can remain on credit reports. There is nothing in the FCRA that requires that an account be removed from a credit report just because it has been paid or settled. The credit reporting agencies are allowed to continue to report it until the full seven years has passed.
Many consumers attempt to negotiate “pay for delete” settlement arrangements with collection agencies. While “pay for delete” arrangements between consumers and collection agencies are not illegal under the FCRA, those deals violate the service agreements between the collection agencies and the credit bureaus.
If a collection agency gets caught granting “pay for delete” settlements to consumers, then the agency could lose its ability to report accounts to the credit bureaus altogether. Anyone who suggests pay for delete deals are common is misleading you.
Myth #2: Credit reports reflect unpaid balance on settled debt
Truth — If a consumer pays the agreed upon debt settlement offer then the balance of the account becomes zero and the credit report should be updated accordingly.
When a debt settlement, formally known as an “offer in compromise,” is agreed upon by a creditor and paid by a debtor the remaining balance on the account is forgiven. Once the debt has been settled the debtor owes no additional monies on the account UNLESS he or she foolishly agreed to be liable for the deficiency balance.
If the collection agency takes the steps to update the consumer’s credit reports then the account balance should be changed to zero. Along with the zero balance, a notation along the lines of “settled for less than full balance” will be added to the consumer’s credit report.
Myth #3: Settling derogatory accounts improves credit scores
Truth — The settlement of a derogatory account will most likely do nothing to improve a consumer’s credit scores.
The reason settling a derogatory account almost never has a positive impact on a consumer’s credit scores is because current FICO and VantageScore credit scoring models are built to predict the likelihood of whether a consumer will miss payments in the future.
If a consumer has missed payments in the past, illustrated by the fact that there are settling debts, then the odds are higher that he will miss payments again in the future.
Settling or paying off the balance of an account does not erase the fact that the default occurred and, therefore, usually does nothing to raise a consumer’s credit scores.
There is one exception to this rule. The most current version of VantageScore, called VantageScore 3.0, and the recently announced FICO 9 credit score will ignore all collection accounts that have a zero balance, regardless of whether it was paid or settled. There are some scenarios under those two scoring platforms where the consumer’s scores could go up.
Myth #4: Debt settlement resets 7-year clock
Truth — Nothing can legally cause a derogatory account to remain upon a consumer’s credit reports for longer than seven years from the date of default on the original account, NOTHING.
According to the FCRA, derogatory accounts have a capped time limit for how long they are allowed to stay on a consumer’s credit reports, called a statute of limitations. This is great news for consumers because it means they cannot be penalized for their past financial management mistakes indefinitely.
Once an account has gone into default, which generally occurs after it becomes six months past due, it can only remain on the consumer’s credit reports for seven years from that point. After seven years from the default, the account will be purged from the consumer’s reports.
You can dispute the item, settle it, pay the item in full, or ignore the item and it still cannot stay on a credit report longer than seven years from the date of default.
Myth #5: Debt settlement is a bad idea
Truth — Even if settling a delinquent debt will not improve a consumer’s credit scores it is still probably a smart financial move.
If a consumer can afford to settle a collection account with a debt settlement then they probably should go ahead and do so. Settling defaulted debts with a debt settlement is a cost effective way to satisfy the creditor and move ahead with your life.
The alternative of ignoring collection accounts is a horrible idea that can lead to judgments being filed against you if you were to be sued by your creditors.
Not only can settling a debt protect a consumer from the aforementioned “legal” collection attempts, but settlements can also save a consumer a ton of money in the long run and stop those annoying collection phone calls. Keep in mind that most defaulted debt is sold for pennies on the dollar so even though the collector is accepting a settlement they’re still making several hundred percent on their investment.
