Does debt forgiveness ruin your credit?

If you're overwhelmed with the amount of debt you've racked up on your credit cards or by taking out personal loans, the idea of settling it for less than you owe might feel like the perfect solution to the issue. And, in many cases, it can be. After all, debt forgiveness promises an expedited path to freedom from crushing balances, and in today's high-rate environment, in which credit card rates are closing in on 22% and personal loan rates are inching toward 13% on average, that type of relief can be hard to find. 

Today's high-rate environment is hardly the only issue at play right now, though. Americans are also carrying a significant amount of debt overall. The total amount of credit card debt alone is north of $1.18 trillion, and many borrowers are struggling just to make their minimum payments as the interest charges compound. So, debt forgiveness can seem like the only way to stay above water for those who feel like they're sinking due to their growing debt.

But like most financial shortcuts, it comes with a few catches. You could owe more on your taxes if your debt is forgiven and your credit score could be impacted during the process, too. Will debt forgiveness ruin your credit, though, or is that damage something you can easily overcome? That's what we'll examine below.

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Does debt forgiveness ruin your credit?

In general, yes, debt forgiveness will hurt your credit. Whether or not it ruins it, though, is an answer that's a bit more nuanced.

Here's how it works: When you settle a debt, you negotiate with a creditor to pay a lump sum that's less than what you owe. In return, the creditor agrees to forgive the remaining balance. Sounds like a win, right? It can be, but when that debt is reported to the credit bureaus, it's typically marked as "settled" rather than "paid in full," and that can raise red flags for future lenders.

Because payment history and account status make up a large portion of your credit score, having a portion of your debt forgiven, thus "settling" your debt, can cause your score to drop significantly. And the more accounts you settle, the more damage you're likely to see.

That's not the only issue, either. When you pursue debt forgiveness, you typically stop making payments while negotiating with creditors and saving up for lump-sum settlements. This shows creditors that you're unable to keep up with the payments, but it also adds late payments and possibly charge-offs to your credit report before the forgiveness process is complete. So, the actual hit to your score can start long before the debt is forgiven.

That said, this damage isn't permanent. Debt forgiveness stays on your credit report for seven years, but the impact lessens over time, especially if you rebuild your credit with on-time payments, a low credit utilization ratio and responsible financial behavior. And, if you already have late payments reflected on your credit report, the settled debts and further late payments may not have as much of an impact as they otherwise would.

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Is debt forgiveness worth the credit damage?

Whether debt forgiveness and the credit damage it can cause is worth it depends on your financial situation and your goals.

If your credit is already in poor shape due to missed payments, high balances or collections, the damage caused during the process might not feel like a major downgrade. In fact, for people on the verge of bankruptcy, debt forgiveness can be a preferable alternative. It lets you resolve your obligations for less than you owe while avoiding some of the long-term consequences of bankruptcy, like a 10-year hit on your credit report and public court records.

Debt forgiveness can also be a smart move if you're trying to avoid wage garnishment, lawsuits or a growing mountain of interest charges. By negotiating a lower payoff, you stop the damage and give yourself a clean slate, especially if you can afford to pay the settled amount in a lump sum and move forward without relying on credit for a while.

On the other hand, if you have a decent credit score, a steady income and manageable debt, you might have better options. A debt consolidation loan, for example, can help you roll multiple balances into one fixed payment, often at a lower interest rate. That keeps your accounts in good standing and doesn't tank your credit. Credit counseling agencies can also help you set up a structured debt management plan that avoids the "settled" mark entirely.

It all comes down to how much debt you have, how far behind you are and how important your credit score is in the short term. If you're planning to buy a house, refinance or apply for new credit soon, the damage from a settlement could cost you more than the savings.

The bottom line

Ultimately, debt settlement doesn't ruin your credit forever, but it does put a dent in your financial record that can take time to recover from. But in certain situations, those downsides can be a necessary tradeoff. The key is to weigh the immediate relief against the long-term impact. If you do decide to settle your debts, make sure you understand the process, the tradeoffs and take steps to rebuild your credit as soon as possible.