Debt Settlement May Hurt Credit Score More Than Bankruptcy

Debt settlement may sound less drastic than bankruptcy, but it was associated with a much steeper credit score decline for some consumers.

Consumers who entered a debt settlement program while current on their financial obligations experienced a substantially larger decline than consumers who filed for bankruptcy, according to new research from TransUnion.

Those consumers saw their median VantageScore 4.0 plunge 96 points, from 645 six months before enrolling in debt settlement to 549 six months afterward.

Bankruptcy filers experienced a median decline of only 20 points over the same period. The difference largely reflects where the two groups started and when the financial damage occurred.

“Debt-settlement enrollees started with much higher scores than bankruptcy filers, with median scores of 645 versus 582, giving them more room to fall,” Michele Raneri, Vice President and Head of U.S. Research and Consulting at TransUnion, told us.

She said many consumers increased their credit card usage and use of unsecured personal loans in the months leading up to debt settlement. After enrollment, balance reductions, account closures and credit utilization changes put additional pressure on their scores.

Debt settlement programs may require consumers to stop making payments before debts can be negotiated, further damaging their credit scores.

“By contrast, bankruptcy filers often exhibit significant financial stress and delinquencies before the bankruptcy appears on their credit file,” Raneri said. “As a result, much of the score impact has already occurred before the filing is recorded, making the additional decline after bankruptcy less pronounced.”

How Delinquency Changed the Credit Score Impact

About half of the consumers who enrolled in debt settlement were current on their financial obligations when they entered a program. They also experienced the largest median score decline.

TransUnion’s data showed that the decline generally narrowed among consumers who were already behind. Consumers who were 30 to 90 days past due saw their median score fall 72 points from six months before enrollment to six months afterward.

Among consumers who were at least 120 days past due when they entered debt settlement, the median decline narrowed to 22 points, closer to the 20-point decline among bankruptcy filers.

Debt Settlement Comes With Other Risks

Debt settlement can damage credit and leave consumers facing continued or escalating collections activity. Creditors are not required to accept a settlement either, Audrey Downs, Communications Manager at GreenPath, told us.

“Most debt settlement programs require pausing payments toward your debt while the settlement is being negotiated, which can lead to late fees and significant credit damage. Settled accounts may also remain on your credit report for years,” Downs said.

Alternatives to Debt Settlement

A debt management plan through a nonprofit credit counselor may offer a less costly, lower-risk path to repayment.

“In many cases, a debt management program (DMP) carries less cost and less risk and can help support long-term credit health by providing a manageable, structured path to repaying debt in full,” Downs said.

Consumers may also want to begin by contacting their creditors, ideally before falling behind on payments.

“Consumers should consider working directly with their lenders or speaking with a nonprofit credit counselor to explore repayment or hardship options,” Raneri said. “These approaches may, in some instances, allow them to keep important accounts open and can be less damaging to credit scores than debt settlement or bankruptcy.”

“Most people considering debt settlement would be much better off in a chapter 7 bankruptcy. It’s faster, more reliable, and cheaper.” — Andrew Pizor, Senior Attorney, National Consumer Law Center

For consumers choosing between debt settlement and bankruptcy, Andrew Pizor, Senior Attorney at the National Consumer Law Center, generally favors bankruptcy.

“Most people considering debt settlement would be much better off in a chapter 7 bankruptcy. It’s faster, more reliable, and cheaper,” Pizor said. “The typical debt settlement program lasts several years. That delays the point when you can start rebuilding your credit.”

A discharge in a routine Chapter 7 bankruptcy typically occurs about four months after filing, although individual timelines can vary.

Credit scores do not follow the same path for every bankruptcy filer, and improvement beginning immediately after filing is not guaranteed.

“And your credit score will start gradually improving from the time you file,” Pizor said.