Year 2017: Raj of Mumbai got into financial difficulties and he had availed 2-3 loans for his business. He found it very difficult to pay EMIs on all of them on time. While he somehow managed to clear of 2 of those loans, he just could not pay the third loan. After giving a lot of time, his bank agreed to settle his loan of Rs 50000 by paying Rs 40000 only.
Raj was happy that the bank let him off and he could get rid of that loan which was proving difficult for him to repay.
Year 2019: Things turned around for Raj and his business has been flourishing. To meet a big client's export order, he applied for a loan with a different bank this time.
He was totally aghast to learn that his credit score was low due to the loan that he settled just 2 years back. And due to the low credit score, his loan was rejected.
We know that Raj is not alone, there are many individuals who knowingly or unknowingly agree to settle a loan without knowing the consequences of doing so.
CreditMantri, as your credit coach, is there at every step of your credit journey to make it obstacle free.
What is Debt Settlement?
Debt settlement is a term used to convey that a lower amount was paid to satisfy and close your debt. But, it’s not a clean closure.
Let's consider the above example: Raj owed his bank Rs 50, 000 (with interest) but he was unable to pay the EMIs or principal on this loan. When you land up in such situations and find it absolutely difficult to repay your debt, your lender may offer you a settlement just to ensure that the account is closed. Here Raj paid only Rs 40,000 to clear off his debt of Rs 50,000.
The option of settlement is used generally as a last resort when the lender is sure that the borrower would be unable to pay the entire outstanding amount, and hence settles for a lower amount. The amount that is agreed as settlement is always lower than the outstanding amount.
Also, debt settlement is done as one lump sum payment rather than in installments.
Debt Settlement can be done in 2 ways
Approach the bank on your own: This is one of the ways in which debt settlement can be done. In case you feel that you cannot pay the outstanding amount, you can approach the bank with a request for settlement. Or it can be done from the bank's end too. If you have not been regular with your repayments, then the bank may offer you a settlement clause to close the account from their books.
Approach the bank for a settlement through a Credit counselor: This may be the case when you approach a credit counselor or take a credit improvement service. The credit counselor may approach the bank on your behalf for a settlement if none of the other ways of meeting your loan obligation work out for you.
We would like to put out a word of caution here when you approach a Credit Counselor or Credit Improvement Service- always go in for ones with a professional approach and good experience. Also, it is important for you to know that banks generally do not agree to settling debt easily, nor is such a practice encouraged.
Pros and Cons of Debt Settlement
It is good to look at both the sides of the coin before you a take a decision about debt settlement.
Helps you reduce debt: If you are saddled with too much of debt and struggling to pay them, then this might help you reduce some debt.
Gives you relief from recovery agents: When your debt is overdue, your banks employ recovery agents to recover the debt from you. Settling a debt may give your relief from their visits and calls.
While there may seem to be some benefits here, we are sure the risks /cons of debt settlement overweigh it.
To settle your debt, you would need to come up with the entire amount in a lump-sum: To make a one-time settlement of your delinquent loan account, you need to pay the entire amount upfront. This may prove to be difficult when you are already struggling with your finances.
Credit score takes a huge hit: By going in for a settlement you are risking the availability of credit in future. A low credit score takes some amount of time for improvement. When your credit score is low or there is a mentioned of a loan Settled in the past, it obviously affects your chances of getting any credit in future.
What Does Debt Settlement Do to Your Credit Score?
Generally, debt settlement is done as a last resort and it is done only for certain cases and not as a rule. When a debt is settled, the same is reported to the credit bureau.
Once reported to the credit bureaus, the settled debt has a negative effect on your credit score. Your credit history will show that one /many of your loan or credit card accounts was settled for a lower amount. This is a huge indicator that you have not been responsible with your debt and could not honor the set obligation of that particular credit.
Consequently, it will show up as a lower credit score and will show up in your credit history for a long time. A settled debt does not give your future lender a positive feeling about your creditworthiness. Hence, will affect your prospects of future credit.
How Can You Avoid Debt Settlement?
As we understand, debt settlement is not a convenient option to get rid of one's debt. We, therefore, bring you some pointers that can help you in situations when you feel that your debt has become unmanageable.
Try Debt Consolidation Loans
Think of going in for Balance Transfer on Credit Card
Opt for easier EMIs on Credit Cards
Go in for a secured loan like Gold Loan /Loan against a FD to clear off the debt in question
Availing an unsecured personal loan to clear off the debt can also be helpful
You could also make small changes to your consumption pattern so that you have some excess funds to pay off the existing loans.
No matter what, the bottom line for maintaining a good credit score remains the same- avail only that much credit which you can pay off and be prompt in your repayment.