How Debt Settlement Can Affect Your Credit Score vs. Creditworthiness
- UpdatedNov 20, 2023
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There’s a lot of talk out there about your credit score—what it is, how to improve it, etc.—and for good reason. Your credit score is an important indicator of your financial health. But it’s actually just one piece of a larger puzzle: your creditworthiness.
Understanding credit scores and creditworthiness is important if you’re considering debt settlement.
What’s the difference between your credit score and creditworthiness?
Your credit score is a three-digit number that tells lenders how likely it is that you’ll repay your debts. Credit scores range from 300 to 850, and higher is better.
Creditworthiness is a bigger picture that includes your credit score. There's no universal definition of what makes a person creditworthy. Every lender gets to decide that for themselves.
How does a lender decide if you’re creditworthy? They have two main considerations: your past experience repaying debt (which they can evaluate by looking at your credit score and your credit history) and your current ability to pay back new debt (which is largely based on your financial situation).
What’s in a credit score?
Your credit score is determined by five factors:
Payment history (whether you pay your bills on time)
Utilization (how much credit card debt you have compared to your credit limits)
Length of credit history (people with the highest credit scores often have at least one credit account that’s decades old)
Inquiries (how many times you’ve applied for new credit accounts recently)
Credit mix (whether you have experience with different kinds of accounts, like loans and credit cards)
What is debt-to-income (DTI) ratio?
The lender’s other main consideration is your current ability to pay back new debt. They look at your debt-to-income (DTI) ratio to determine this.
Simply put, your DTI ratio is the percentage of your monthly income that goes toward debt, including housing.
In order for a lender to feel comfortable with your ability to repay a new debt, they need to know you have the necessary income to do so. By understanding how much of your income goes toward paying debt right now, they can determine if you have enough left over to pay back the new debt.
Although each lender sets their own acceptable DTI standards, a DTI below 28% is considered excellent. The upper cutoff could be between 35% and 50%, depending on the lender and the type of loan you’re applying for.
A high DTI could make you look less creditworthy, even if you have a great credit score. This can be especially frustrating if you are trying to get a loan to pay off that debt.
How does debt settlement affect your credit score?
Debt settlement relates to your payment history and your account status. Let’s look at payment history first.
Many people are already behind on their payments when they start looking at debt settlement as a solution. Payment history influences your credit score more than anything else, so in this situation, the person would typically already have credit score damage.
Let’s say you’re not behind on your payments yet, or you’re not far behind, but you have a financial hardship and you decide to try to settle your debt for less than the full amount you owe. If you choose to stop making payments so that you can save up enough money to make a settlement offer to your creditor, you should expect some credit score damage. Because again, missing payments for any reason is bad for your credit.
Once you successfully settle a debt, the account status will show up in your credit history as “settled.” This tells anyone looking at your credit reports that you didn’t repay the debt in full, but you did work out an agreement with your creditor. So where your credit score is concerned, a “settled” account isn't as good as “paid in full,” but it’s better than a delinquent account or unpaid collection account.
The key thing to know about credit scores is that they change every time new information is reported to the credit bureaus, including the passage of time. Even if you settle debts, your score can recover.
How does debt settlement affect your creditworthiness?
When you settle a debt, you’re not obligated to pay any more money on it and you’re no longer responsible for the minimum payment. Freeing up some of your income could improve your DTI ratio and signal to lenders that you now have room in your budget to take on new debt, making you more creditworthy in their eyes. That means you may now get approved for the credit you need to buy a new car, make home improvements, or whatever else you’ve been waiting for.
Debt settlement can help you reach your financial and credit goals
Debt settlement is a serious solution to big debt problems. Although your credit score may take a hit in the ways we’ve described, the effect is temporary. Getting out of financial trouble, on the other hand, could have long-lasting benefits. Addressing your debt is the first step toward building and maintaining a healthy credit score and stable financial life.
The Freedom Debt Relief debt settlement program could help you reduce your overall debt burden. Most of our clients can complete their program in 2 to 4 years. * When you graduate from our program, you’ll be free of your enrolled debts, Call one of our Certified Debt Consultants at 800-910-0065 to get started.
