Planning to Opt for Loan Settlement? Here’s Why This is a Bad Idea

Ajay Mishra had taken a loan to fund his home redecoration project. Unfortunately, after just a year of repayment, his business went through losses and he could not afford to continue repaying the loan. Without considering other options, he decided to opt for a loan settlement assuming that he will be free from the burden of repayment.

In the end, not only was his credit score severely impacted, he could not get a loan easily after.

Most believe that a loan settlement is the easiest option to choose when repayment is not possible. This is, however, far from the truth.

Let us understand the impact of loan settlement on your finances.

What is Loan Settlement

what is loan settlement

When you take a loan, it is understood that it will have to be repaid over time which is why, as borrowers, you are always advised to take one only when you are sure of your repayment ability.

But sometimes, circumstances can get the best of us and despite our best efforts we end up being unable to repay a loan. In such situations, the borrower can come to an agreement with the lender who will offer a one-time settlement option. 

The borrower will ‘settle’ the loan by paying a lump sum which is lower than the original repayment amount. The interest and penalties are written off as well. Once this payment is made, the lender will close all accounts and report the loan as ‘settled’.

Note: This is not to be confused with ‘loan closure’ which is when a loan is fully paid on time with interest.

How Does Loan Settlement Affect your Credit Score

impact of loan settlement on your credit score

At first glance, settling a loan seems like the easy way out if you are unable to repay a loan. However, this can have a severe impact on your credit score, potentially preventing you from getting a loan easily in the future.

Your credit score determines your creditworthiness, including your repayment abilities. Higher the score, the more reliable you are according to the lender which is why you can get loans easily.

However, when you ‘settle’ your loan, regardless of the circumstances, your repayment ability is now in jeopardy. When lenders report this information to the Credit Bureau, your credit score will immediately drop significantly and this in turn will affect your loan eligibility.

Unfortunately, credit bureaus do not consider the situation that has prompted you to settle your loan or relationship between you and the borrower. If a loan is marked as ‘settled’, your credit history will be impacted negatively.

While you will be able to improve your credit score by following certain guidelines, it will still take some time which is why opting for loan settlement should be avoided as much as possible.

What Can You Do Instead?

what to do instead of loan settlement

In case you are finding it difficult to repay your loan, here are some options to consider instead of opting for loan settlement –

  • If you have any assets such as land or jewelry, consider liquidating them and raising funds to repay your loans. Once your circumstances improve, you can buy these back
  • Try to borrow the amount required from family or friends. Not only will you have more of a leeway when it comes to repayment, your credit score won’t be affected even if you default (which should be avoided)
  • If you have a good relationship with your lender, you can request for an extension of the repayment period or a waiver of the interest for some time which may help you repay more easily

Things to Keep in Mind Before Taking a Loan

things to keep in mind before taking a loan

If you are taking a loan, ensure that you are in a position to repay it fully. However, in order to protect yourself against unavoidable circumstances, here are some steps you can take –

  • If you have taken a large loan amount, ensure that you have assets that can be liquidated as a safeguard. In case you are unable to repay your loan, these assets can you help you raise money
  • Consider taking a loan insurance plan to protect yourself. Even if you are unable to repay the loan, the insurance plan will help protect your finances
  • Borrow only within your capacity. Just because you are eligible to borrow does not mean that you should, unless you can repay it

In Conclusion

Opting for a loan settlement should not be considered unless every other option is exhausted. Your credit score will be impacted by this and you will not be able to get loans easily. Even if you do, the interest rates will be high, making it harder for you to repay them.

Have you ever considered settling your loan? What did you do instead? Let us know in the comments below!