How Settling Auto Loan Debt Affects Your Credit Score

How Settling Auto Loan Debt Affects Your Credit Score

Getting a new car is exciting! But those monthly car payments can really add up. If you’ve fallen behind on your auto loan payments, you may be considering settling your debt for less than you owe. This can help relieve some financial stress in the short term, but it also has consequences for your credit score.

Settling an auto loan basically means negotiating with the lender to pay a lump sum that is less than the remaining loan balance. For example, if you owe $10,000 still and can come up with $6,000, the lender may agree to call it even so you can avoid default. It can be tempting to take this route if you’re having trouble keeping up with payments. However, debt settlement should really be a last resort option.

How Settling Debt Affects Your Credit Score

When you settle a debt instead of fully paying it off, your credit score will take an initial hit. Here’s a look at some of the main impacts:

• Your credit score can drop 100 points or more, depending on your starting score.
• Settling an account shows that you did not fulfill the full loan obligation.
• The settled account will be marked “settled for less than agreed” or something similar on your credit report.
• This negative mark will stay on your report for up to 7 years.
• Settling debt lowers your credit utilization ratio, but the negative mark outweighs this benefit.
• Multiple settled accounts on your report increase the damage to your score.

The higher your credit score was before settling, the larger the drop typically is. Someone with “good” credit around 680 may see their score fall to the low 600s. If you had “very good” credit around 750, your score could sink below 700. Even if your score was only fair to start, it will still take a hit from debt settlement.

Weighing the Pros and Cons

Settling your auto loan can negatively affect your credit, but failing to make payments at all can be even worse. Your creditor has options like repossessing your car or suing you over the unpaid debt. Before making a decision, think carefully about these key pros and cons:

Potential Pros

• Allows you to avoid defaulting on the loan
• Stops accruing late fees and interest penalties
• Lets you keep possession of the vehicle in some cases
• Provides immediate financial relief
• May be better than declaring bankruptcy

Potential Cons

• Large initial drop in credit score
• Negative mark stays for up to 7 years
• May make it harder to get approved for future loans or credit
• Does not address underlying issues leading to unaffordable debt
• Creditors may still be able to sue for the remaining balance

You can see that while settling has some benefits like letting you keep your car, the credit impacts are very real. And if you can’t address ongoing problems like job loss or overspending, more financial issues could arise down the road.

When Debt Settlement May Make Sense

Though it’s generally considered a “last resort” option, there are some situations where settling your auto loan could be the right call:

• You experience a crisis like job loss or medical emergency – An unexpected crisis can make it impossible to keep up with payments. Settlement may help you get by until you recover financially.
• You have very poor credit already – If your credit score is already low, a settlement won’t make as much of an impact. It may be preferable to default.
• You owe much more than the car is worth – Being upside down on your auto loan changes the math on whether to settle versus surrendering the car.
• You have other negative marks on your report – If you already have late payments or other dings on your credit, one more may not dig you into a much deeper hole.

You may also want to settle your auto loan if you meet certain conditions for a “strategic default.” This is when you purposefully stop making payments because the debt exceeds the value of the collateral. Auto loans are a common target for strategic defaults since cars depreciate rapidly.

How to Minimize Damage to Your Credit

If you determine debt settlement is your only viable option, take steps to protect your credit as much as possible:

• Do not miss payments on any other credit accounts while settling your auto loan.
• Avoid charging more debt to your credit cards before or after settling.
• Continue paying other bills and loans on time.
• Pay down balances on revolving credit to lower your utilization ratio.
• Only settle an account after it is at least 120 days past due.
• Ask the lender not to report it as settled for less if you pay a substantial portion of the balance.
• Send goodwill letters asking creditors to remove late payments reported while settling.

Following the above tips will help limit the fallout to your credit. Keeping other accounts in good standing is critical, as lenders look at your overall payment history – not just one settled debt.

Rebuilding Credit After Settlement

The effects of settling your auto loan on your credit score will diminish over time. You can speed up your credit repair process by taking actions like:

• Pay all other accounts on time going forward.
• Keep credit card balances low.
• Become an authorized user on someone else’s credit card.
• Limit new credit applications.
• Wait at least a year after settlement to apply for more credit.
• Consider a secured credit card to add positive history.
• Monitor your credit reports and dispute any errors.
• Practice better money management and budgeting.

Within a few years of smart credit use, your scores can potentially recover significantly. However, the settled account will continue weighing down your credit until it falls off your report after about 7 years.

Alternatives to Auto Loan Settlement

Settling your car loan for less than you owe should really be a last ditch option. First explore some other paths that won’t trash your credit scores:

• Loan refinancing – You may be able to get a lower monthly payment by refinancing your auto loan.
• Payment extensions – Ask your lender for a short-term hardship extension or deferment on payments.
• Credit counseling – Non-profit credit counseling services can help you manage debt and negotiate with creditors.
• Debt management plan – A DMP provides structured payment relief and consolidated payments through a counseling agency.
• Bankruptcy – Filing for bankruptcy stops collections and wipes out certain debts through liquidation or reorganization.
• Voluntary repossession – You can voluntarily surrender the car to satisfy the loan and avoid a forced repossession.

If you exhaust all of the above options, debt settlement on your auto loan may be a reasonable last choice before default. Just be prepared for the negative effects it will have on your credit.

At the end of the day, there are no easy answers when you cannot afford your car loan payments. Consider all angles of your financial situation, and think about your long-term goals. Getting professional advice from a credit counselor or financial advisor can also help guide your decision making. With some sacrifices now and diligent effort, you can recover from credit damage down the line.