Loan Settlement Can Ruin Your Credit Score

While applying for a loan, you may plan to repay the taken amount after a certain time. But what if you find yourself in such a situation where you are no longer working and are unable to meet your repayment commitment. You may think of approaching your lender where there is a possibility that they might offer you an option of One-Time settlement (OTS). Here, you would most probably want to grab this opportunity and take this offer up, however, little did you know, it might take a toll on your Credit Score.

What Does Loan Settlement Mean?

Loan/Debt settlement is also known as debt arbitration, debt negotiation or credit settlement. It is an approach to debt reduction in which the debtor and creditor agree on a reduced balance that will be regarded as payment in full. During this period of negotiation, all payments by the debtor are made to the debt settlement company, which typically withholds payments to the creditors, even if the debtor has paid a lump sum or made payments. Once all the debtor's accounts are in default due to non-payment, the debt settlement company has the leverage to force the debtor to accept a reduced lump sum payment as settlement. The debtor's credit rating or credit score goes down significantly due to the default, especially if the debtor was not behind on payments before the negotiation period commenced. Even though the accounts are "settled”, the default appears on the debtor's credit record for seven years.

How Does a Lender Process This?

If a borrower has turned delinquent for a time frame of six months or more, a bank is likely to offer an OTS (One Time Settlement), if they are convinced by the reason given by you for non-payment such as your job loss or any serious medical issue. The lender will write-off a certain amount so that it is easier for the borrower to settle the loan in one go. Due to this negotiation agreement, the status of your loan will be marked as ‘settled’. And if the borrower had paid the outstanding balance in full, in that case, the status of the loan would be recorded as ‘closed’.

How Does Loan Settlement Impact Your Credit Score?

Whenever a lender decides to write-off your loan, they immediately report this case to the CIBIL and other credit bureaus. Though the loan transaction comes to an end in the form of settlement between the borrower and lender, but it is still not considered as 'Closed' by CIBIL, they term it as 'Settled'. When a loan is termed settled, it is viewed as a negative credit behaviour and the borrower’s credit score drops by approximately 75-100 points. If during this period, a borrower applies for any fresh credit, it might get difficult for the lenders to approve such applications.

How Can Borrowers Deal With This?

Borrowers may see 'Write-off' as an opportunity to pay less for the time being to close their loan account. However, most of the borrowers aren't aware of the consequences of such a settlement. Until and unless you don't have another option, do not get swayed by this option offered by the lenders. If possible, choose to liquidate your savings or investments to pay off the outstanding loan amount in full. Generally, it is recommended to consider ‘settlement’ as a last resort.

Apart from this, you can request your lender to extend your repayment term, re-evaluate the monthly instalment structure so it is easier for you to make monthly payments, reduce the interest rate, or at least waive-off the interest for as long as possible.

Once your lender agrees with you, make sure to verify the changes that may happen on your credit report and score. Maintain a good credit score and behaviour and try to make up when you notice a dip in that. To further avoid such situations, you can go for a secured loan instead of going for an unsecured one so that the lender will not have to be worried about your repayment capabilities. Alternatively, you can also take an insurance policy against the loan. In this case, even if you come across a tough situation where you cannot repay, the insurance does the needful for you. Therefore, you will not default on payments and it won’t affect your credit score.

What You Should Remember?

  • Always try to stay within your means and borrow that much which you can easily repay on time.
  • Remember that your credit score will drop considerably when you choose this option to close your loan. This will make it hard for you to qualify for any kind of credit products in the future.
  • Debt/Loan settlement may look like a tempting option for you when you are unable to repay your outstanding debts on time. But you should always remember, it negatively impacts your credit score. So, try to go for this option when you are left with no other option.