How to use a settlement or judgment to pay off debt and improve credit

When you have taken legal action against an individual or company, you may have been awarded money for damages. It could have come from a settlement where you and the other party agreed to an amount that both of you can live with without having to go to court. Or maybe you took it all the way and you won a lawsuit which resulted in a judgment in your favor. In either case, you now have a sum of cash at your disposal.

Although money from settlements and judgments can feel like a windfall and your first inclination may be to splurge, slow down and take a clear look at your entire financial picture. You’ll want to spend it wisely. Very often that will include paying off debt and improving your credit rating.

Prepare for taxes

Before getting too excited, understand that money may not be all yours. You may have to pay taxes on the award. According to the Internal Revenue Service (IRS), most such awards are considered income, so are taxable events. Unless it is exempt by a section of the IRS code, prepare to send a portion of the money to Uncle Sam.

So, what settlements and judgements are exempt? In general, it would be compensation you received for personal physical injuries. For example, if you sued a doctor for medical malpractice or got hurt in a car accident, the entire award is likely yours to keep. You do not need to report it to the IRS or to your state tax board.

In all other situations, the settlement or judgment award is considered income, so you’ll have to pay taxes on it. Worse, the bill may be higher than you anticipate. Congress passed a law allowing the IRS to tax plaintiffs on the full gross amount, not just the net of what you get after your lawyer has deducted fees. So if the award was $100,000 but you only received $60,000, you’ll have to pay taxes on the $100,000. Yes, ouch.

You will want to get this right, so speak with a tax professional before taking any action with the money. The last thing you want is to spend it all, then receive a 1099 Form in the mail come tax time and not be able to pay it.

So if you will owe taxes, set money aside for it or pay the amount due now, before it starts to be absorbed into your budget.

Pay off credit cards and other high-interest debt

Once you have a post-tax figure, you can start to figure out what to do with the rest of the money. And one of the most important tasks is to take a hard look at your debts, should you have them.

Obtain the most recent balances for all of your credit cards and loans. Review the interest rates that are attached to each.

As you can see, when the interest rates are high, you are losing money when those financing fees are included. As much as you may want to splurge and use the money for something fun, wait and delete costly debt first. When you do, you will also give yourself a financial break. You won’t have to send your creditors the payments anymore, which will cause your budget to suddenly expand.

Some creditors may not be charging you any interest, but they are also important. These include utilities and medical providers such as physicians, hospitals and dentists. If you don’t satisfy them, they can land in collections, so pay them before that happens. Same with personal obligations. If you borrowed money from friends and family members during your time of need, now is the time to make good on those debts.

Also a priority are secured accounts, most notably mortgages and car loans. If you’re behind on those bills, use some of the money from your case to get back on track. This will be especially important if you are facing foreclosure and repossession.

Check your credit

Now, take a look at your credit reports. Go to AnnualCreditReport.com and pull all three reports from TransUnion, Equifax and Experian. You will want to make sure that the information you see is correct. If it’s not, dispute inaccuracies.

You may have experienced legitimate credit damage because of whatever happened that led you to the lawsuit. For example, because you couldn’t work and earn as normal, your reports may show evidence of late credit card and loan payments, accounts that were charged off or sent to collections, car repossessions or defaulted student loans. If so, your credit scores are being negatively impacted.

Access your FICO Scores or VantageScores to learn your credit rating. They range from 300 to 850 with higher numbers being preferable:

• 300-579 = poor
• 580-669 = fair
• 670-739 = good
• 740-799 = very good
• 800-850 = exceptional

Don’t worry if your sores are at the bottom. Consider it a starting point, since they will change with your activity.

Deal with remaining debt

When you delete revolving debt, your credit scores will be recalculated based on the new activity. Therefore, if you had high balances compared to your credit lines and now owe nothing, your credit scores should increase.

You will also see a scoring increase after clearing up debts in collection agencies. The most current scoring models (FICO® 9, and the VantageScore® 3.0 and 4.0) don’t factor in collections that have been zeroed out.

If you are behind on car payments and mortgages, you can get the accounts back in good standing by paying what you owe. Once they show up as current on your credit report, your credit scores should increase.

Just be aware that it won’t erase all past credit problems. For example, delinquencies will remain on your credit report for seven years, while Chapter 7 bankruptcy will remain for 10 years from the date you filed.

Add positive credit information

Now you also can add regular positive information to your credit reports, which will eventually offset the negative marks:

• Use open accounts again. If you have credit card accounts that are still active, start using them again, but this time make sure you pay the balances in full and always on time.
• Apply for a new credit card. If you don’t have any open accounts, apply for one that matches your current credit profile and lifestyle. Because your credit has been damaged, focus on cards designed for people with low credit scores. Consider a secured credit card and putting some money from your judgment or settlement as collateral. The more you put down, the larger your credit line. This way you can charge even expensive items without hitting your limit. Depending on the credit card, it may convert to an unsecured account after handling it well after a period of time.
• Pay all loans on time. If you fell behind before, now you can get back on track. Every on-time payment will be recorded on your credit report and factored favorably into your scores.

Once your credit scores are in a better place, you may want to apply for a credit card that is best for you, or take out a loan with a low interest rate. Just be sure to maintain the same pattern of perfect payments, and low or no carried-over debt on your credit cards.

Spend rationally

You may have denied yourself simple pleasures while waiting for that award to come through. Now that you have it, it’s time to ease up after paying off all that debt, right?

To some degree, yes. It will also be very important to take a long view on your financial picture. If your budget has been extremely constrained, you can loosen it up with the money you have left at your disposal. Identify the things that you need and have been putting off, like new clothes or a functioning laptop.

The point is to concentrate spending on the goods and services that are most valuable to you and your family. You don’t have to stick only to essentials. Maybe it is time for a vacation. Evaluate your needs and meet them first, then allow yourself the luxury of something more extravagant.

Prepare for the future

One of the biggest stressors that people have is not being able to pay for emergencies. In fact, according to a 2022 Money and Mental Health report, developed by Bankrate and Psych Central, 57 percent of those surveyed cited insufficient emergency savings as having the most negative impact on their mental health.

Don’t let this happen to you. In most cases, going through a lawsuit is already a psychologically difficult event, so do yourself a favor and set a portion of the money aside in the following categories:

• Emergencies. Some should be for the unknown, like job loss and higher than expected costs. In general, that means having three to six months’ worth of essential expenses in an account that you can draw from without penalties being added.
• Higher education. College can be wildly expensive. According to the Education Data Initiative, the average cost is $35,331, including books, supplies and daily living expenses. So if your kids are going, you may want to fund a tax-advantaged 529 plan.
• Enjoyment. Also hold back a certain sum for the things that you want to do that give you pleasure. You can use your credit card to pay for them (especially if you get rewards) and then use the money in the savings account to delete the debt.
• Retirement. If you have neglected saving for your retirement, and those years aren’t so far in the future, fund your retirement account with at least some of the money.

The bottom line

Getting a lump sum of cash can be an intoxicating experience, especially if you’ve had to live within a tight budget for years and have been weighed down by pressing bills. By following this plan, you will use the settlement or judgment wisely. Moreover, you’ll have good credit products and excellent credit scores that will help you not just today but for many years to come.