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Michelle Clardie
Michelle Clardie is a seasoned investor who’s been writing professionally about saving and investing since 2017. She used the investment advice she covered to quit her day job in property tax consulting and move abroad, writing her way from one country to the next. With a Master's in Business Management and Strategy from WGU, Michelle specializes in making complex personal finance topics easy to understand.
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Aylea Wilkins
Aylea Wilkins has been at Bankrate since 2019, editing content in student, personal and home equity loans and auto, home and life insurance before taking on editing content in a variety of other categories. She has nearly a decade of editorial experience with a primary focus on helping people confidently make financial and purchasing decisions by providing clear and unbiased information.
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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.
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 payment.
A car loan settlement 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:
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.
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.
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.
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.
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.
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:
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. While settling an auto loan can relieve an overwhelming debt, it also brings a lower credit score, higher income taxes, and potential challenges in future loan applications or apartment rentals.
When in doubt, seek advice from a reputable credit counseling service to make sure your decision aligns with your long-term financial plans.
Michelle Clardie is a seasoned investor who’s been writing professionally about saving and investing since 2017. She used the investment advice she covered to quit her day job in property tax consulting and move abroad, writing her way from one country to the next. With a Master's in Business Management and Strategy from WGU, Michelle specializes in making complex personal finance topics easy to understand.
Aylea Wilkins has been at Bankrate since 2019, editing content in student, personal and home equity loans and auto, home and life insurance before taking on editing content in a variety of other categories. She has nearly a decade of editorial experience with a primary focus on helping people confidently make financial and purchasing decisions by providing clear and unbiased information.
