Loan Settlement Procedure and Its Impact on Your Credit Score

When you apply for a loan, it's important to be aware of your loan repayment capacity. Hence, many lenders urge you to calculate your monthly EMIs before applying for a particular amount so that you can pay off your debt without facing any financial difficulty and opting for loan settlement.

There may be scenarios when you may have applied for a loan for a particular tenure, but you are unable to repay it within the stipulated time given by your lender. In such a situation, you may approach your lender/bank and request them for loan settlement. Your lender will certainly help you provided you have a genuine reason for requesting for loan settlement, and your loan will be settled with the help of the One Time Settlement (OTS) option.

However, it may have an adverse effect on your credit score and you may not be eligible for applying for loans in the future. Read more to know about the impact of loan settlement on your credit score and its subsequent outcome.

What is Loan Settlement and How It Works?

The loan settlement procedure is also known as the debt settlement procedure that refers to an agreement between a lender and a borrower whereby the borrower pays back a portion of the total borrowed amount while the remaining debt or unpaid amount is forgiven by the lender. A lender may offer One Time Settlement (OTS) to a borrower when a borrower has a genuine reason like a serious injury, medical emergencies, loss of a job or other urgent reason.

Your lender will provide you the One Time Loan settlement when it agrees to accept a lesser amount than the actual amount that is due, and also agrees to waive off or write off the unpaid amount. The lender may agree to loan settlement only after a certain period provided the reasons for the inability to repay the debt are genuine. Once the loan settlement is done between the lender and borrower, the lender will close the loan in its loan book and mark it as ‘settled’, and the borrower will no longer be a customer.

Should You Opt for Loan Settlement?

Ideally no! Go for any type of loan settlement – be it a personal loan debt settlement or any other debt settlement, only if it is the last option left with you. You can try out the following means before opting for loan settlement –

  1. Try to repay the loan as far as possible liquidating your investments like Mutual Funds, Fixed Deposits, and Insurances policies.
  2. Request your lender to extend your loan tenure.
  3. Opt for debt consolidation where you can opt for a new loan to pay off your existing debt/loan.
  4. Opt for a mortgage loan or secured loan by pledging financial assets like gold, properties, etc., and pay off the current debt.
  5. Have a contingency plan; keep backup funds to meet unpredictable situations in life.

Please keep in mind that the option of settling a bank loan should be considered by you when you have exhausted all other savings and left with no other option but to request for loan settlement. This is because when you opt for a debt settlement plan, it changes and negates the original credit agreement between you and your lender. Also, when your lender reports the same to the credit rating agencies as ‘ settled’ instead of ‘paid as agreed’ or ‘paid in full’- this will have a negative impact on your credit score, and discourage other lenders to lend you credit in the future.

What is the Impact of Loan Settlement on Your Credit Score?

Did you ever know that settling a loan may hurt your credit? Yes, it may negatively affect your credit history and bring down your credit score drastically that may limit your chances of receiving credits in the future. This happens because when you request for loan settlement due to a genuine reason and your bank/lender accepts your request, you end up paying a lesser amount than the amount originally agreed between you and your lender. After the settlement is over, the status of the loan will be marked as closed in the bank loan book, but your name may be on the list of loan defaulters. Besides, your lender will report the same as ‘settled’ to the credit bureaus. This will bring down your credit score affecting your credit history, and it may take several years to build up a good credit score and clear off the negative remark from your credit report.

How Does Loan Settlement Impact the Borrower?

The very act of opting for loan settlement by a borrower always has a negative impact on his/her credit score. A ‘settled’ loan is always considered as negative behavior by the credit rating agencies because here the borrower fails to make the complete repayment of the borrowed amount; he/she pays only a part of the entire amount. This significantly brings down the credit score of a borrower and makes it hard for him/her to get any credits/loans in the future. For a borrower, it takes nearly seven years or so to reestablish a positive score and improve his/her credit history.

Difference Between Loan Settlement and Loan Closure

It is seen that borrowers often confuse between ‘Loan settlement’ and ‘loan closure’. While loan closure is a term that refers to the complete closure of an existing loan after the borrower pays off all monthly installments and the loan repayment is complete on time as agreed between lender and borrower earlier. Here, the lender will close the loan account and the borrower shall have no other liabilities. Your lender will also send the same information to the credit rating agencies. And this will have a positive impact on your score as you have successfully paid off your debt on time.

On the other hand, when a borrower fails to repay a particular loan and requests for loan settlement, the lender may offer the OTS facility and write-off a certain amount so that it becomes easier for the borrower to settle the loan in one go. After this, the lender will immediately send a report to the CIBIL and other credit bureaus mentioning that the loan has been settled. Although the loan is practically closed between the lender and borrower, the status of the loan will be recorded as “settled as the borrower could not repay the entire amount and the lender had to write –off a certain amount. And this may have a negative impact on the borrower’s credit score, and he/she may face difficulties in obtaining credits in the future.

Things to Remember While Opting for Credit

Being a little cautious while opting for credit will help you avoid multiple problems related to borrowing and your overall financial management. It’s important to keep in mind the following points when you decided to opt for credit from the bank or any other lenders-

  • Apply for credit carefully. Borrow as per your requirement.
  • Avoid taking multiple credit cards or loans unless you really need and manage it responsibly
  • Pay off your monthly EMIs on time at the scheduled date
  • Keep monitoring your CIBIL Score at regular intervals to keep a track of your financial performance. Having a good credit score always helps you receive further credits smoothly.
  • When you opt for One Time Settlement, don’t apply for a new loan immediately after the loan settlement. Wait till your credit score is restored. It is because there are chances that your loan application may be rejected due to the ‘settled’ status of your previous loan and it may further affect your credit score.
  • Focus on building up your savings so that you have enough funds to cover your EMIs in emergency situations, instead of opting for loan settlement.
  • You should always be within your repayment capability. Don’t borrow more than your repayment capacity. This may bring severe trouble in terms of managing your finances.

How to Improve Your Credit Score?

A good CIBIL score always helps you to enjoy a number of benefits like -

  • Faster loan approval
  • A low-interest rate on the credit facility
  • Higher loan amount
  • Longer repayment period
  • You can choose your lender at your convenience as multiple lenders will be willing to approve your loan if you have a good credit score.

A CIBIL score that stands between 700 to 900 is usually considered a good CIBIL score. On the other hand, if you have a low or bad credit score, you may face the following difficulties -

  • You may find it difficult to get a loan or credit.
  • Bank may charge you a higher rate of interest on a loan
  • You may have to pay higher processing fees
  • Your loan application may be rejected.

A low credit score always exposes a lender to a high risk of default. Therefore, banks or lenders are often unwilling to offer credits to individuals who have a low credit score and who have defaulted loan payments in the past.

Hence it is very important to maintain a good CIBIL score to increase your chances of receiving credit easily at reasonable rates. You can build up a good credit history by practicing the following –

  • Paying credit card bills and monthly EMIs on time without defaulting.
  • Paying off all your existing debts without opting for loan settlement.
  • Not applying for multiple credits.
  • Utilizing your credit responsibility. Don’t overspend
  • Monitor your credit reports regularly to identify if there is a negative factor present in your credit history so that you can take necessary measures to improve the same.