Let’s imagine, for a moment, that you’ve racked up $15,000 on your credit card and haven’t been able to make the monthly payments for nearly a year. Your penalties for missed payments keep growing, as does the interest. Now imagine that the bank, nervous you’re going to default, reaches out to you one day and offers to settle that debt for, say, $8,000 instead of $15,000. Sounds like a blessing, right?
Debt settlements come in a few different forms and each one has its own set of repercussions — the main one being that your credit score will take a hit. Your credit score is a three-digit number that’s calculated using five factors: payment history, percentage utilization, credit history, delinquency history and inquiries (where a lender runs a hard check on your score). Lenders can use your score for everything from approving you for a credit card to approving you for a mortgage.
Sometimes, when the debt hits the fan, settlement is the only way out, but it’s important to look at the different ways you can settle your debt, and how each will affect you.
Lender to borrower settlement
Let’s start with the example of a lender reaching out to a borrower to settle. While that’s rare, it does happen. But here’s why you should think twice before agreeing. One: it’s not legally binding. “You could do everything they tell you to, and a year from now they could say ‘deal’s off, sorry,’” says Scott Terrio, manager of consumer insolvency at Hoyes, Michalos & Associates Inc. If it wanted to, the bank could reinstate the original balance and interest.
Two: if you have debts with lenders other than this one bank, this settlement solves only part of your problem. “Let’s say you’ve got $50,000 total in debt,” says Terrio, “and this bank comes to you with a settlement offer that's only looking after $25,000 of that. You don’t really have a settlement.”
So, how does all of this affect your credit score? When creditors settle with you, they’re allowed to load what’s called an R7 rating onto your credit report. The “R” stands for “revolving” or “recurring” credit, and the 7, which is part of a 0-to-9 rating system, is what indicates that some sort of settlement was made on that credit. (Other types of debt, such as lines of credit, are classified using a different letter).
Any negative information (and the R7 is negative) that a lender loads onto your report generally stays there for six years, which will bring down your credit score and make it more challenging for you to access credit in the future. Now, the lender isn’t obligated to load the rating onto your report, but they won’t tell you whether they have or not. To find out, you’d have to request a copy of your credit report. If your debt has gone to collections, the collections agency can also load the R7.
Debt consolidation loan
This is a form of debt settlement that’s initiated by the borrower. Let’s say Jane Smith has a $15,000 line of credit, an $8,000 Mastercard debt and another $7,000 on a Visa — all with the same bank. Jane’s been struggling to make the payments on these three debts, each of which continue to collect their own high-rate interest. She might ask the bank to consolidate all of her debts into one loan with one interest rate.
“Now, they’re going to lend that to you,” says Terrio. “They're lenders. They’re not giving you a break.” If the bank agrees, it will decide what the rate on the new loan is. On the surface, fewer debts sounds like a step in the right direction, but if you really think about it, says Terrio, a consolidation won’t solve your problem, either. You still have debt, and you’re still paying interest on that debt. “You’ve just swapped three debts for one.”
With a consumer proposal, your creditors actually give you a break. There’s a structured payment plan, but no loan. Money does not change hands
Terrio sees lots of people who have gotten a consolidation loan. They might not be paying 19% interest on two credit cards, he says, but they’re likely paying 10 or 15% on the entire amount they owe. This “out-of-the-normal-course of credit payback” would also get you an R7, says Terrio. But again, it’s up to the lender whether to load it onto your credit report or not.
Debt settlement agencies
Then there are debt settlement companies, who, for a fee, will negotiate with your creditors and offer them a lump sum of money to eliminate your debt. This lump sum is often less than the amount of your actual debt. If the creditors accept, then you pay the debt settlement company, who turns around and pays your creditors. Then your creditors can decide whether to load the R7 onto your credit report or not.
“I’m not going to have very much good to say about these places,” says Terrio, referring to the significant pushback from the financial industry against these outfits in recent years because some can mislead or outright scam consumers. The Financial Consumer Agency of Canada has issued a consumer alert cautioning the public that some of these companies misrepresent their services as being part of a government program; some pose as licensed trustees, some encourage customers to use a high-interest loan to pay back their debts; and some promise to quickly and easily fix a consumer’s credit score.
Even if the company is operating ethically, there’s no guarantee that creditors will accept the offer a debt settlement company brings them — or that debt settlement companies will even make the offer at all. Many consumers have found this out too late, after having paid the company a fee, and wound up in more debt than they were in before.
“Most of them pose as trustees,” says Terrio, “and charge you $1,000 or $2,000, or more, and then they introduce you to me. Now, you could have skipped all of that and come to see me for free. So, you just blew $2,000 for nothing, and then they walk away and all of a sudden you can’t find them anymore.” When people do get to Terrio’s office, he says they’re soured on the whole idea of settlement.
Terrio helps clients file what’s called a consumer proposal — a legal action that’s an alternative to bankruptcy, where, along with a licensed insolvency trustee, the borrower makes a formal debt repayment plan over a certain period of time to pay back a portion of all the debt they owe, and the lender forgives the rest. All your unsecured debts must go into this proposal. Secured debts that are backed by an asset, like a mortgage or a car loan — stay out. Someone like Terrio is paid out of the funds that are distributed to your creditors, not by an upfront or separate fee.
A consumer proposal will still get you an R7 on your credit report, but it will stay there for only three years after you’ve paid off all the debts. “It’s fairly forgiving,” says Terrio. Equifax will remove the proposal from your report three years after you’ve paid off all the debts. TransUnion will remove it three years after you’ve paid off the debts, or six years after you sign the proposal — whichever comes first.
“With a consumer proposal, your creditors actually give you a break,” says Terrio. “There’s a structured payment plan, but no loan. Money does not change hands.” The consumer comes out on the other end with no unsecured debts because they’ve all been wiped out.
That’s important because this makes the effect a consumer proposal has on your score a bit different. “Yes, that R7 will slow you down for the three years, but you have no debt, which is going to pull your overall credit score up because your utilization score is going to be good,” Terrio says. Plus, having your debt servicing costs at zero can be helpful when applying for, well, more debt.
You can devote way more of your income to repaying a car loan, for instance, than somebody who’s also making monthly payments to two credit cards and a line of credit. Of course, the repercussions of any debt settlement depend entirely on what is reported to the credit bureau and who ends up looking at your report down the road. That’s why it’s crucial to first explore all of your options, and find out a) what’s in it for the lender or other party, and b) what it’s going to cost you not just in terms of money, but in terms of credit rating, too.
“Remember,” says Terrio. “It’s a deal. So, everything comes at a price.”