What ramifications will debt write-off have on credit score?

George heard a debt settlement advertisement on his way to work claiming he could,

“Pay just 50% of what he owed."

Currently he owes $16,000 in credit card debt most of which was charged by his wife who he says is terrible with money.* He is tired of paying her debt and would love to have half of it written off. George called the debt settlement company and was told for an upfront fee plus 18% of the balance written off they would negotiate a settlement. His question for me was what effects if any would the debt written-off have on his credit score?

Let start with ~ How does a debt settlement company work?
George has been making his monthly credit card payments on time and is current on all his other debts. As a rule, creditors won't negotiate with consumers who are current on their bills, often refusing to discuss settlements with anyone who is not at least three to six months behind. Knowing this the debt settlement company will instruct George to stop making payments to his creditors. Instead he will make payments to the debt settlement company, after taking the first couple of payments as their fee; the debt settlement company will make offers to his creditors to settle his debt for a lump sum payment. This lump sum payment will come from the amounts he has paid to the debt settlement company.

What this company didn’t tell George is that debt settlement only works for a few of the consumers who attempt it; not all credit card companies will settle. Consumers who enter the process may endure months of creditors' angry phone calls, plus a growing debt load as fees, penalties and interest are tacked on to their original balance due. Plus, there's the possibility creditors will sue.

If George is successful in obtaining a debt settlement how will it be reported on his credit report?
Debts paid off as part of a negotiated settlement will generally show “Paid by Settlement” on a consumer’s credit report. If he were to apply for a new loan, the prospective lender will understand that a debt paid by settlement means that his repayment did not cover the total debt that he had accumulated, and that his creditor accepted a lesser amount.

How will a debt write-off affect his actual credit score?
His credit score is based on information contained in his credit report, with the highest consideration given to how he repaid his debts. As stated above, the first thing the debt settlement company will instruct George to do is to stop paying his debts.

According to Liz Pulliam Weston's article 5 ways to kill your credit scores:

The 680 scorer would lose 45 to 65 points with this maneuver, while the 780 scorer would shed 105 to 125 points.

Our scenario assumed that borrowers would miss one payment before settling the debt with their credit card companies. In reality, debt settlement negotiations can drag on much longer, with each missed payment taking another chunk out of your score.

Settling a debt with a collection agency would hurt less, probably much less, because the FICO formula is set up to weigh more heavily what the original creditor says about you than what a collection agency reports. But if our borrowers were settling with a collection agency instead, their scores would be lower to begin with, because they would have collection accounts on their records.

Long-term effects:
The long default on payments, followed by the settlement for less than you owed, is going to stay on your credit report for seven years and look just as bad, or worse, than a bankruptcy (particularly a chapter 13 bankruptcy.)

Other considerations:
George will receive a 1099 form from each of the credit card companies he settles with. The amount of debt forgiven is considered income and is taxable.

This is the hidden cost of higher insurance rates (insurance companies now check credit reports when renewing auto policies) and higher interest rates on any debts he might incur in the future.

What to do instead:
Before George goes the settlement route, he should visit a consumer-credit counseling agency for advice. The first visit is free.

The National Foundation for Credit Counseling (http://www.nfcc.org/) has a tool for locating counselors nationwide. Credit counselors offer debt-management plans. Under these, creditors agree to accept reduced monthly payments or lower interest rates in return for the consumer agreeing to pay the full debt on a set schedule. But consumers who can't afford the monthly payment won't qualify.

Next, he should talk to an attorney to assess whether bankruptcy makes sense. Debt settlement "is not a decision you make without talking to a bankruptcy attorney, because you could be sued" by going the settlement route.

He should try to negotiate with the credit card companies himself:
George did call two of the credit card companies. One said their company did not negotiate debt settlements. The other would not consider debt settlement at this time because he is current with his payments. As a courtesy, they checked his credit report finding only one bad mark; a late student loan payment from several years ago. The only relief they could offer currently was to restructure his debt over a five year period. During this time he could no longer use his credit card to make purchases, but his total outstanding credit would show on his credit report. They could not reduce his interest rate; he already had the lowest rate they offered. He did not accept the restructure.

Realizing debt settlement was not an answer to his problems George is now looking for other methods to get out of debt.

*I recommended George and his wife take one of Dave Ramsey's money management classes offered at many churches in our area. I know several couples who have taken this class and have found it to be helpful.