How to Use a Settlement to Pay Off Debt and Improve Credit
When you filed a lawsuit against an individual or company, you may have received compensation for damages. It could be from a settlement where you and the other party have agreed on an amount you can both live with without having to go to court. Or maybe you made it all the way and won a lawsuit that resulted in a judgment in your favor. In either case, you now have a sum of money at your disposal.
Although the money from settlements and judgments may seem like a godsend and your first inclination may be to splurge, slow down and take a clear look at your overall financial picture. You will want to spend it wisely. Quite often this will include paying off debt and improving your credit rating.
Prepare for taxes
Before you get too excited, understand that the money might not be all yours. You may have to pay taxes on the prize. According to the Internal Revenue Service (IRS), most of these awards are considered income, just like taxable events. Unless he’s exempt by some section of the IRS code, be prepared to send some of the money to Uncle Sam.
So which settlements and judgments are exempt? Typically, this would be compensation you received for bodily injury. For example, if you sued a doctor for medical malpractice or were injured in a car accident, you’ll likely be able to keep the full reward. You do not need to report it to the IRS or your state tax commission.
In all other situations, the settlement or judgment is considered income, so you will have to pay taxes on it. Worse, the bill may be higher than expected. Congress passed a law allowing the IRS to tax plaintiffs on the full gross amount, not just the net amount of what you get after your attorney deducts the fees. So if the reward was $100,000 but you only received $60,000, you will have to pay taxes on the $100,000. Yes, ouch.
You’ll want to get it right, so talk to a tax professional before you take action with the money. The last thing you want is to spend it all and then get a Form 1099 in the mail at tax time and not be able to pay it.
So if you owe taxes, put money aside or pay the amount you owe now, before it starts to go into your budget.
Pay off credit cards and other high interest debt
Once you have an after-tax figure, you can start figuring out what to do with the rest of the money. And one of the most important tasks is to carefully examine your debts, if you have any.
Get the latest balances for all your credit cards and loans. Review the interest rates that are attached to each.
As you can see, when interest rates are high, you lose money when these finance charges are included. Even if you want to splurge and use the money for something fun, wait and get rid of expensive debt first. When you do, you will also give yourself a financial break. You will no longer have to send payments to your creditors, which will lead to a sudden increase in your budget.
Some creditors may not charge you any interest, but they are also important. These include public services and medical providers such as doctors, hospitals and dentists. If you don’t satisfy them, they can end up in collections, so pay them off before that happens. Ditto for personal obligations. If you borrowed money from friends and family when you needed it, now is the time to pay off those debts.
Secured accounts are also prioritized, including mortgages and auto loans. If you’re behind on those bills, use some of your case money to get you back on track. This will be especially important if you are dealing with a seizure and repossession.
Check your credit
Now take a look at your credit reports. Go to AnnualCreditReport.com and pull up the three reports from TransUnion, Equifax, and Experian. You’ll want to make sure the information you see is correct. If not, challenge the inaccuracies.
You may have suffered legitimate credit damage from whatever happened leading up to your lawsuit. For example, because you couldn’t work and earn normally, your reports may show evidence of late credit card and loan payments, accounts that were debited or sent for collection, car seizures, or student loans. in default. If so, your credit ratings are negatively affected.
Access your FICO scores or VantageScores to see your credit score. 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 wounds are at the bottom. Consider it a starting point, as they will change with your activity.
Manage remaining debt
When you remove revolving debt, your credit scores will be recalculated based on the new activity. Therefore, if you had high balances relative to your lines of credit and no longer owe anything, your credit scores should increase.
You will also see an increase in rating after settling debts in collection agencies. The most recent scoring models (FICO® 9 and VantageScore® 3.0 and 4.0) do not account for collections that have been zeroed.
If you’re behind on car payments and mortgages, you can get accounts back in good standing by paying what you owe. Once they show up as current on your credit report, your credit scores should go up.
Just be aware that this will not erase all past credit issues. For example, defaults will remain on your credit report for seven years, while Chapter 7 bankruptcy will remain for 10 years from the date of your filing.
Add positive credit information
Now you can also regularly add positive information to your credit reports, which will eventually offset the negative ratings:
- Use opened 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 an account open, 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 put money from your judgment or settlement as collateral. The more you invest, the larger your line of credit. This way you can load even expensive items without hitting your limit. Depending on the credit card, it may be converted into an unsecured account after handling it well after a while.
- Repay 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 better, you may want to apply for a credit card with great rewards or take out a low-interest loan. Just make sure you maintain the same perfect payment pattern and have little or no deferred debt on your credit cards.
You may have deprived yourself of simple pleasures while waiting for this reward to be given. Now that you have it, it’s time to relax after paying off all that debt, right?
To some extent, yes. It will also be very important to have a long-term view of your financial situation. If your budget has been extremely constrained, you can loosen it with the money you have left. Identify things you need and have carried over, like new clothes or a working laptop.
The goal is to focus spending on the goods and services that are most valuable to you and your family. You don’t have to stick to the basics. Maybe it’s time to go on vacation. Assess your needs and meet them first, then treat yourself to the luxury of something more extravagant.
Prepare for the future
One of the biggest stressors people have is not being able to pay for emergencies. In fact, according to a 2022 report on money and mental health, compiled by Bankrate and Psych Central, 57% of respondents cited insufficient emergency savings as having the most negative impact on their lives. Mental Health.
Don’t let this happen to you. In most cases, going through a trial is already a psychologically difficult event, so do yourself a favor and set aside some money in the following categories:
- Emergency room. Some should be for the unknown, such as job loss and higher than expected costs. Typically, this means having three to six months of essential expenses in an account that you can draw on without penalties.
- Higher Education. College can be extremely expensive. According to the Education Data Initiative, the average cost is $35,331, including books, supplies, and daily expenses. So if your kids are moving away, you might want to fund a tax-efficient 529 plan.
- Enjoyment. Also, set aside some money for the things you want to do that make you happy. You can use your credit card to pay for them (especially if you get rewards) and then use money from the savings account to clear the debt.
- Retirement. If you neglected to save for your retirement and those years are not so far away, fund your retirement account with at least some of the money.
The bottom line
Getting a cash lump sum can be a heady experience, especially if you’ve had to live on a tight budget for years and been weighed down by pressing bills. By following this plan, you will use the settlement or judgment wisely. Plus, you’ll have good credit products and great credit scores that will help you not just today, but for many years to come.