Should you pay off debt or settle it?

If you have accumulated a decent amount of credit card debt, you may be wondering what your options are for paying it off. Of course, you always have the option of paying off your balance in full, but you may also be curious if debt settlement is something worth pursuing.

In some cases, you can negotiate with your lender to pay off a smaller amount of debt than you actually owe in exchange for making a lump sum payment. While this may seem like the obvious path to take (who doesn’t want to save money?), you may find that pursuing debt settlement is not worth the time and effort or the potential damage to your credit score.

Keep reading for more insight into whether or not it is better to pay off your debt or to settle it.

Is it better to pay off or settle debt?

Here’s the good news – whether you decide to pay off your debt in full or settle your debt, you’ll end up debt free.

Which path you decide to take will depend on whether you want to prioritize saving money or protecting your credit score.

Settling your debt can hurt your credit score, but can also save you money. It’s worth noting that settlement is usually only an option once a lender writes your debt off as a loss, which happens when someone is very overdue on debt payments. Ideally, you’ll always make your minimum debt payments on time.

If you want to save money by pursuing settlement, all hope is not lost on the credit score front. Settling your credit card debt and paying it off will help lower your credit utilization ratio which will improve your credit score. Your credit utilization ratio represents how much of your available revolving credit you’re using. When you pay down a form of revolving credit like a credit card or line of credit, you reduce the amount of credit you are utilizing and lower your credit utilization ratio.

Ideally, you’ll keep your credit utilization ratio below 30%, but the lower you can get it, the more you’ll see your credit score improve. Your credit utilization is the second most important factor in FICO’s credit scoring model – after making on-time payments – so paying down revolving debt is a really effective way to boost your credit score.

Paying off your debt in full without settling will cost you more, but it’s the fastest way to get out from under your debt because settling it is not a quick process. And taking longer to pay off your debt by waiting for a settlement offer to come through can damage your credit score further.

Take taxes and fees into account

When you make a decision regarding paying your debt in full or settling it, it’s important to keep the tax implication of settling in mind. You have to pay taxes on “forgiven” debt. If the forgiven amount is more than $600, you will receive a 1099-C Cancellation of Debt tax form from the creditor or collection agency with whom you settled.

The IRS requires that you report any amount of forgiveness for that tax year because it’s considered income. When added to your taxable income, the money you just “saved” via a settlement could cost more than anticipated. In addition to taxes, you may also have to pay fees to settle your debt. It’s important to pay attention to these extra expenses because as your savings diminish, the value in settling diminishes as well.

If settlement is the only way you can afford to pay off your credit card debt, just make sure you set aside enough money to pay those extra taxes.

Things to keep in mind when settling

Before you decide to settle your debt, you need to take its status into consideration – in particular, whether it’s being reported as a charge-off or it’s being sent to collections.

When card debt is reported as a charge-off

One of the reasons your credit score can be impacted negatively by settling is that once a charged-off debt has been settled, the creditor will typically begin reporting the account to the credit bureaus as having been “settled for less than the full amount due.”

And just as the score sees a charge-off as a derogatory event, it also sees a settled account in the same way, despite the debt having essentially been wiped out.

When it comes to credit scoring, the length of time since an account encountered payment problems can be one of the most critical negative factors in a credit score. That is, a recent negative item can be expected to cause much more score damage than an older one. This is why scores tend to improve over time once problems have been resolved.

So, when a card goes from being reported as a charge-off to being settled, even though the outcome is better, the more recent settlement date on the negative item can lead to a lower score than it was prior to settling, as part of the “time since the most recent delinquency” calculations.

When card debt is sent to collections

Whereas a recent debt settlement can hurt your score when it replaces a charge-off as the latest negative status, the worst, and last, step along this timeline is much less complicated.

Using the most widely used FICO models, once a bad debt has been sent to a collection agency, it will no longer “matter” to the score whether the debt is ultimately paid in full or settled. Unlike a debt settled at the charge-off stage, no reporting change occurs when a collection goes from unpaid to either paid-in-full or settled.

The date the debt was assigned to the collection agency tends to be the only one that will be used to measure its recency, regardless of the eventual outcome.

Bottom line

There are both pros and cons associated with settling or paying off credit card debt in full. When making that decision, it’s important to take the true cost of settlement – including taxes and debt settlement company fees – into account.

You should also keep in mind the impact of the debt resolution on your score’s recovery, particularly when settling a pre-collection charge-off. Take your time to consider each option carefully and remember that whichever way you choose to do it, paying off your credit card debt is something to celebrate.