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What is loan settlement? How does it affect your credit score?

A loan, if used smartly, can prove to be an effective financial tool to procure financing to meet your financial requirements. For most of our financial goals, we save, invest, and plan. However, there could be some situations where we might need funds to fulfill personal or business obligations. It could be for your children’s higher education, a medical situation, or urgent business capital funding, etc. A long-term financing need could be for buying a house and a short-term need could be for a vacation. But the problem arises when we either don’t have sufficient savings or assets to liquidate or we don’t want to sell our assets to generate funds. In such cases, we may have to borrow money from a lender in the form of a secured (against collateral) or unsecured (without any collateral) loan.

Life is unpredictable and you might yourself in a situation where you are unable to service the loan EMIs. This could be due to job loss, a disability, loss in business, or a financial crisis. When you inform your lender about your inability to honour the repayment commitment, the lender can offer to ‘settle your loan’. It sounds lucrative as you might not be aware of the implications. A loan settlement affects your credit score negatively. And this could harm your future loan plans.

What is a Loan Settlement?

Loan/Debt settlement is also known as debt arbitration, debt negotiation, or credit settlement. It is an approach where the lender and creditor arrive at a common ground after the borrower expresses his/her inability to repay the loan due to unforeseen circumstances. The final loan amount is mutually agreed upon, which is less than the loan outstanding amount and is paid by the borrower to the lender as a one-time payment.

You should opt for a loan settlement only when you have exhausted all other avenues of repaying the loan as the loan settlement affects your credit score negatively. The one-time loan settlement is not offered to all debtors but only to those who can prove their genuine inability to repay the loan. It is a way for lenders to reduce further risks associated with that particular loan and to reduce debt obligations for borrowers.

How Does Loan Settlement Work?

You should be willing to accept a dip in your credit score when you agree to a loan settlement. The process is not automatically available for all debtors who are unable to repay a loan.

Here are the steps that are commonly followed while settling a loan:

  • The borrower intimates the lender about his/her inability to repay the loan due to an unforeseen circumstance. The lender verifies the genuineness of the claims and if convinced, offers a one-time settlement option.
  • The settlement amount (less than the outstanding loan amount), is mutually agreed upon after assessing the borrower’s repayment capacity and the severity of the situation.
  • After writing off the interest and penalties, the final settlement amount is repaid by the borrower in a single payment.
  • Upon completion of the payment and other formalities, the lender ‘writes off' the loan, the loan account is marked ‘settled’ and it is then closed and reported to the credit bureau.

It may seem like a good way to get rid of the debt, the borrower pays a heavy price on the loan settlement with his credit score.

Difference Between Loan Settlement and Loan Closure

Although loan settlement and loan closure are often used interchangeably, there’s a stark difference between the two.

Loan Closure Loan Settlement
Refers to the closing of an existing loan account after the borrower repays the loan fully on time. It is process of paying off a debt to a lender an amount that is lower than the outstanding loan amount when the debtor is unable to repay the loan.
Indicative of your creditworthiness. Indicative of negative credit behavior.
Lender doesn’t have to settle for less to mitigate its risk. Lender ‘writes off’ the loan to reduce further risks in the loan.
A good repayment track record increases your credit score. Decreases your credit score considerably.
Helpful in procuring future loans. Hampers your eligibility for future loans.

If a borrower is unaware of this difference, he/she could opt for a loan settlement that will hamper his/her credit score.

How Does Loan Settlement Impact Your Credit Score?

When you ‘settle’ your loan, you are effectively paying your lender less than what is due. It may get rid of your debts for the meantime, but it wreaks havoc on your credit score after a loan settlement. And this can make it difficult for you to secure funding from lenders in the future.

As soon as you pay the full and final amount for the loan settlement, the lender reports it immediately to CIBIL and other rating agencies. Although the loan account will technically be closed, the remarks on the loan account will be ‘settled’. The borrower’s credit score drops by 75-100 points. An important point to note is that these agencies hold on to this information for about seven years. And during this time, if you apply for a loan, lenders will be cautious about granting you a loan and may even reject your application. So, unless there is no other option left for you to repay the loan, a loan settlement is not advisable.

Alternatives to Avoid Loan Settlement

A loan settlement may seem like an attractive option (paying less than the due amount), but accepting the offer may not be a wise financial decision because of its far-reaching consequences. Accepting a loan settlement offer should be your last option.

Before you accept a loan settlement offer-

  • Use your savings or liquidate your investments and other assets to pay off the loan.

  • Borrow money from friends and family.

  • Take a low-interest loan like a gold loan.

  • Negotiate with your lender to restructure your loan, reduce the interest rate or extend the repayment tenure.

  • Take an insurance policy against the loan and pay the premiums diligently. The insurer pays the lender in case of default.

How to Avoid Falling into the Debt Trap?

Availing of a credit facility and its subsequent repayment requires disciplined credit behavior. Because of the above, it is always advisable to

  • Borrow within your repayment capacity limits.

  • Always keep an emergency fund handy to tackle the possibilities of default.

  • Repay and close loans diligently.

  • Use credit cards, personal loans, and Buy-Now-Pay-Later schemes responsibly.

  • Monitor your credit score regularly and take actions to improve it in case the score dips.

  • When you opt for loan settlement, your credit score drops. Don’t apply for a new loan immediately. Wait until your credit score improves.

With a barrage of credit options, we may get swayed by lucrative offers to borrow for things we do not need. Being a little cautious and mindful when applying for credit goes a long way in building your creditworthiness and avoiding financial mismanagement.

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