How a car loan settlement affects your credit

If your finances are tight, high monthly payments on bills like your auto loan can be more difficult. In those occasions, you may be looking for various options for debt relief.

A car loan settlement can potentially discharge your debt for less than the amount owed. However, before you get too excited about having some of your debt forgiven, you need to understand how debt settlement works and the consequences of a car loan settlement.

What is a car loan settlement?

A car loan settlement is when a borrower negotiates with the auto lender to pay less than the full amount due. The primary catch is that the borrower must make a lump sum payment for the agreed-upon amount by the agreed-upon date.

For example, let’s say a borrower owes $20,000 on their auto loan. However, with their current financial situation, they don’t see any way they’ll ever be able to repay this amount and all the interest that accumulates over time.

The borrower contacts the lender, explains the situation and offers to pay $12,000 within 30 days if the lender will forgive the remaining $8,000. The car loan is settled if the lender agrees and the borrower follows through with the car settlement payment.

How debt settlement impacts your credit

The car loan settlement process immediately causes your credit score to go down because the settlement is a negative mark on your credit report. Your credit score is used in future loan applications, rental applications and, in some cases, employment applications.

The lower your score, the less likely you are to qualify for those things. Even if you are approved for a loan, the lender might require a higher interest rate. Similarly, a landlord might approve your rental application with an increased security deposit.

The severity of the credit score drop varies. Generally, the higher your score is before the loan settlement, the more it will go down after the settlement. A settled account will remain on your credit report as a derogatory mark for seven years after the original delinquency date.

Settling an auto loan affects your FICO score in other ways, too. Your FICO score considers many factors, including length of credit history and credit mix:

• Your length of history is the average amount of time your credit lines have been active. When a debt, like an auto loan, is settled, the line is closed, which reduces your overall average.
• Credit mix refers to the types of debts you carry. Installment loans like home loans, auto loans and student loans are viewed favorably while consumer debts, like credit cards, are viewed negatively. Settling your auto loan could shift your credit mix unfavorably.

Tax consequences of debt settlement

When you settle an auto loan for less than the total amount due, the creditor writes off the difference. The IRS treats this amount as taxable income, which means you have to pay taxes on it.

You should receive a 1099-C cancellation of debt tax notice from the creditor. It will inform you how much you have to pay taxes on. When you file your annual tax return, you must claim this amount as income. Because the money is treated as income, it is taxed based on your standard income tax bracket for that year.

When is debt settlement a good idea?

Despite these downsides, settling an auto loan is better than failing to repay the loan, also known as default. A default negatively impacts your credit score more than settling because each missed payment creates a negative mark on your credit record. Overall, it might make sense to strike a loan settlement deal if taking the immediate hit to your credit score can help your score in the long run.

If you struggle to make regular payments and can’t pay off the auto loan completely, settling your car loan allows you to put the debt behind you and start rebuilding your credit. Plus, your debt-to-income (DTI) ratio is instantly improved with the debt discharged. Lenders and landlords consider DTI when reviewing applications.

Car debt settlement vs. repossession

Settling your car loan is different from vehicle repossession. With an auto loan settlement, you agree with the lender to pay a portion of your original debt. Your debt is then settled.

With repossession, the lender takes possession of the vehicle and sells it to pay off some or all of your debt. If the car sells for less than the amount you owe, you owe the lender the difference. This is called a deficiency payment.

Repossession can be voluntary or obligatory. You could turn in your car to the lender so they can sell it. However, if you fail to make your loan payments, the lender can repossess the vehicle without your consent.

Debt settlement and repossession both impact your credit score negatively. Since late payments often precede both, you may have multiple negative marks in your credit history.

Alternatives to auto loan debt settlement

The best option for your credit is always to pay off your debt in full, but that’s often too tall of an ask. If you can’t do that, try to work with your lender to find the best solution. You may want to seek credit counseling to determine what would be best for your situation.

• Allow your car to be repossessed: As discussed, vehicle repossession negatively impacts your credit, but it is still an option. Before deciding on this alternative to debt settlement, talk to a credit counselor to determine the best option to protect your credit.
• Consolidate your debts: Debt consolidation means taking out one new loan to repay all your existing loans. This reduces the number of bills you have to pay monthly, which can make it easier to manage repayments. Depending on the terms of your consolidation loan, your monthly payment on the consolidated loan may be lower than the total of your current bills, but you might pay more interest over the loan term.
• File for bankruptcy: If your car payment isn’t your only financial issue, you could file for bankruptcy. This is a last resort, as it negatively affects your credit for up to 10 years.
• Modify your car loan: Depending on your situation, you may be able to modify your car loan by negotiating the terms of your loan with your lender. For example, you might ask if they will accept a lower interest rate or extend the loan term to spread your balance across more payments. Just know that extending the loan term typically means paying more in total interest expense.
• Pay off the loan as planned: If there is any way to continue making payments as scheduled, that is the best option for protecting your credit. You could cut non-essential expenses or generate more income with a side hustle.
• Sell your vehicle: If your car is worth more than the loan balance and you have an alternative means of transportation, you may want to consider selling it. The proceeds would be used to pay off the auto loan, and you can pocket the rest to help with other expenses.
• Trade in your car: If your car loan is too expensive, consider trading in your car for a less expensive vehicle. This could lower your monthly payment.

How to rebuild your credit after settling a car loan

When you settle an auto loan, your credit score goes down. After, you can focus on rebuilding your credit. Here are several quick tips for improving your credit after settling an auto loan:

1. Continue to pay all bills in full and on time. Each on-time payment demonstrates responsible credit usage and boosts your score. Plus, as you pay down debts, your credit utilization ratio improves, which further helps your FICO score.
2. Do not apply for new lines of credit, such as credit cards. New lines of credit temporarily decrease your credit score because they reduce the average age of your credit lines.
3. Do not close accounts as you pay them off. When you pay off a credit card, keep that account open to avoid reducing your average length of credit history.

Bottom line

Before pursuing a car loan settlement, it’s important to understand the immediate and long-term effects this decision might have on your financial health and credit score. The long-term damage does not always outweigh the short-term result of loan settlement.

Keep in mind that while settling an auto loan can relieve an overwhelming debt, it also brings a lower credit score, higher income taxes and future challenges when applying for loans. When in doubt, seek advice from a reputable credit counseling service to make sure your decision aligns with your long-term financial plans.