How Settling A Car Loan Affects Credit

It can be difficult to manage an auto loan with the hidden costs of car ownership on top of your other monthly expenses. A car loan settlement can potentially discharge your debt for less than the amount owed, but you need to understand how debt settlement works and the consequences. There are tax implications and alternatives of a car loan settlement you should consider before you jump in.

What is a car loan settlement?

A car loan settlement involves negotiating with the auto lender to pay less than the full amount due. If the lender agrees to a settlement, you 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 forgives the remaining $8,000. The car loan is settled if the lender agrees and the borrower follows through with the car settlement payment.

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 your lender and file it with your annual tax return. The settled amount is treated as income and is taxed based on the standard income tax bracket for that year.

When is settling a car loan a good idea?

If you struggle to make regular payments and can’t manage your auto loan, settling your car loan allows you to put the debt behind you and start rebuilding your credit. Settling a car loan is better than failing to repay the loan and defaulting. Both will impact your credit score and may affect your future ability to borrow, but a default has more consequences for your credit score than debt settlement.

Overall, settling your car loan could make sense if you are able to swing a large lump-sum payment. This is difficult for many people, so an alternative may be a better option if you aren’t able to put thousands toward paying off a car loan.

How car loan settlement impacts your credit

The car loan settlement process may cause your credit score to go down because it is a negative mark on your credit report. Your credit score is used in future loan applications, rental applications and, in rare 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 rental application may still be approved — but with an increased security deposit.

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.

The severity of the credit score drop varies based on a number of factors. 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.

Alternatives to auto loan debt settlement

The best option for your credit is always to pay off your debt in full, but that’s not always possible. If you can’t do that, try to work with your lender to find the best solution. You may also want to seek credit counseling for advice on what would be best for your situation.

• 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.

• 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 lower your monthly payments. Just know that extending the loan term typically means paying more in total interest.

• Refinance your car loan
  

  Similarly, you can look into refinancing your car loan. This allows you to borrow from a different lender, sometimes at lower rates or with a longer term. Both are intended to get you lower monthly payments.

• Trade in or sell your car
  

  If your car loan is too expensive, consider trading in your car at a dealership or selling it privately. You can then buy a less expensive vehicle that better fits your budget.

• Consolidate your debts
  

  Debt consolidation means taking out one new loan to repay all your existing loans. Depending on the terms of your debt consolidation loan, your monthly payment may be lower than the total of your current bills — but you might pay more interest over the loan term.

• Allow your car to be repossessed
  

  Vehicle repossession negatively impacts your credit, but it is still an option. You can ask to have your car voluntarily repossessed to avoid a lengthy and expensive process.

• File for bankruptcy
  

  If your car payment isn’t your only financial issue, you may want to speak to a lawyer about filing for bankruptcy. This is a last resort and a lengthy process, but it can bring substantial relief to your

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.

Debt settlement and repossession both impact your credit score negatively. Since late payments often precede either option, you may have multiple negative marks in your credit history regardless of if you settle your debt or have your vehicle repossessed.

How to rebuild your credit after settling a car loan

After you settle an auto loan, you can focus on rebuilding your credit.

1. Continue to pay other bills. 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. Avoid new lines of credit. New lines of credit temporarily decrease your credit score because they reduce the average age of your credit lines.
3. Keep your accounts open. Keep your credit card accounts open while you pay them off to avoid reducing the length of your credit history and increasing your credit utilization ratio.

Bottom line

Before pursuing a car loan settlement, understand the immediate and long-term effects this decision might have on your finances. The long-term damage does not always outweigh the short-term benefits of settling a car loan.

Keep in mind that while one car settlement payment can end 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.