Loan Settlement – Pros, Cons and Impact on Your Credit Score
Some financial terminologies are often misunderstood by most people. The terms Loan Closure and Loan Settlement are used interchangeably; however, the meanings are entirely different. When the lender closes the loan after receiving the complete instalments, it is known as loan closure. Whereas, when a borrower exposes his inability to pay the loan amount to the lender and requests for a one-time settlement option, it is known as loan settlement.
Loan closure has a positive impact on your credit score, whereas loan settlement hurts your credit score. A borrower’s inability to repay may be due to several reasons such as injury, illness, loss of job, loss in business, etc. If the lender agrees to settle the loan at a lower amount, the credit report reflects the status as “settled”.
How does Loan Settlement work?
Life is unpredictable. A borrower takes a home loan or personal loan to repay it sincerely, but certain circumstances may make the repayment difficult and even impossible. When the borrower fails to pay the instalments for six months, the lender looks into the reasons for non-payment. Reasons such as loss of job, business losses, critical illness, sudden death, etc., are significant reasons for non-repayment of loans. Then, seeing the genuine concerns of the borrower, the lender may allow a one-time settlement of the loan.
The bank discusses the issue with the borrower to analyse the situation. Both agree on an amount to write off the difference between the amount paid and the amount outstanding. If the borrower agrees to pay the settlement amount, the loan would be recorded as settled in the credit reports. Though it is a sigh of relief for the borrower, it would reflect on their credit score.
What is the Impact on Credit Score?
As soon as the banks are ready for loan settlement, they inform the credit rating agencies like CIBIL. When the loan is settled in such a manner explained above, it is not considered a usual closure. Therefore, the credit rating agencies record it as “settled” not “closure”. This process adversely impacts your credit history and your credit score drops significantly.
These agencies hold on to this information for about seven years. In these seven years, if you apply for a loan, there are high chances that it may get rejected due to your low credit score and
poor credit history. A higher credit score indicates a low risk of default. The credit score ranges from 300 to 900, and a score of 750 is considered ideal by the lenders.
The grace period for loan repayment is for 90 days. If the banks do not receive repayment instalments from the borrowers for 90 days, it will be declared as a non-performing asset (NPA). After 180-270 days, the lenders decide to write-off the loan. The loan settlement amount can happen before or after the write-off period.
If the loan is settled before the write-off period, it will be updated as “settled” in the credit report. However, if the loan is settled after the write-off period, it will be updated as “post-write-off settled”. The similarity in both scenarios is that it would adversely impact your credit score.
How to Avoid Loan Settlement and Maintain Your Credit Score?
Poor credit score results due to a lack of awareness among the borrowers. Borrowers should always apply for a loan within their individual repayment capacity. Generally, borrowers get greedy and land into trouble. To maintain your credit score, you should avoid loan settlement at all costs.
Try to find out other options such as using an emergency fund, asking for help from friends and family, sell equity or gold to repay the loan. You can also request the banks to extend the repayment term, reduce the interest rate, waive off interest payments, or re-evaluate the monthly structure to avoid loan settlement.
You should always work toward having a contingency plan. It is ideal to have adequate savings, emergency funds, and FDs to use the amount when required. You can also take insurance on the loan amount. As per the insurance policy, the insurance company would pay the remaining instalments if the borrower is unable to repay the loan.