Loan settlement is often mistaken as loan closure. But they are not the same. Loan closure is when you pay off all your EMIs on time and complete repayments as scheduled. In this case, the lender closes your loan account on payment of the final EMI and issues a NOC (No Objection Certificate).  This information will thus be passed on to the credit bureaus and it has a positive impact on your credit scores as you have paid off your loans successfully. 

Then what is a loan settlement? If you have settled your loan, then what to do next? Can it affect your credit score? Read on to know more about loan settlement and its consequences.

What is a loan settlement?

Imagine you have taken a loan from a lender. For quite some you are not able to make payment due to some underlying conditions such as an illness or job loss or any injury leading to disability or some other reason. In such a situation you are supposed to inform your lenders and request them to guide you so that you can find a way to repay the remaining balance. 

Being a defaulter not only affects the lenders but also the creditors. That is why lenders usually offer a one-time settlement as an option to borrowers where they can take some time off and then settle the loan in one go. Since this offer gives borrowers an opportunity to settle an existing debt for a lower amount, they may readily accept this offer. However when you choose for loan settlement, your loan status will be recorded as ‘settled’ in the credit report. While this is a better option than defaulting, it’s not as good as “closed.” 

What happens in loan settlement?

If you are successfully able to convince the lender for your reason of non-payment then there are high chances that they may offer you a six month non-repayment period. But this will be offered only on one condition that the borrower pay off the balance in one payment as loan settlement at the end of the six-month period. The lender may write-off a certain amount so that they can settle up the loan. Written-off loan amount will depend on the severity of the scenario and the repayment capabilities of the borrower.

Because a negotiated settlement takes place, the status of the loan will be marked as ‘settled’ after the amount is paid. But if the borrower has paid the balance in full then the status of the loan would have been marked as ‘closed’.

How does loan settlement impact your credit score?

When a loan is written off that information is passed on to the credit bureau so that the credit report can be updated. The word ‘settled’ does not usually mean closure. At least not in loan settlement. That is why it is marked as ‘settled’ making other lenders view it as a negative credit behaviour. This can even cause your credit scores to drop, impacting your chances of securing a future loan. 

Generally information on debt settlements stay on the credit report for up to seven years. This can come in a negative light when the borrower wishes to take a loan during those seven years as there are chances of the loan application to get rejected.

Alternatives to Loan Settlement 

Borrowers' mentality can make them assume that a settlement is a better option as they don’t have to pay the entire amount on the outstanding.  However, what they miss out in understanding the inner workings  and calculations of such a settlement. When borrowers settle a debt, it can potentially hurt their credit report for seven whole years because that is how long credit bureaus hold the information in their repository.

Until and unless this does not bother you don’t get swayed by the loan settlement option. Remember that debt settlements should be opted only when it's absolutely necessary. Here are the other options you can choose instead of one-time loan settlement.

  • You can choose to liquidate your savings and or investments such as bank deposits, mutual funds or fixed deposits to pay off the outstanding loan amount in full. 
  • Or you can try requesting your lender to extend your repayment term or re-evaluate the monthly payment structure of your EMIs so that it can be easier to make monthly payments. There are other options too such as reducing the interest rates or atleast waive-off the interest till the situation is manageable.
  • Come up with possible ways to raise money that will be enough to close the loan account. Loan settlement is recommended but only as a last resort. 

When you and your lender are done with the negotiation, make sure to check the final changes that happen on your credit report and credit score. Try to maintain a good credit score from that moment onwards to further avoid any dip in the score. Make up for the low scores. 

It is suggested to opt for secured loans rather than relying on unsecured ones so that the lender will not have to worry about your repayment capabilities. You can also take an insurance policy against your loan. This way the insurance policy will come in handy even if you face a difficult situation where you cannot repay the outstanding. Therefore this won’t let you become a defaulter and won’t affect your credit score.

Final Thoughts

It is highly advisable to borrow within your repayment capability and not as per your requirement. Remember that borrowing is easy but repaying is more difficult. The reason why one-time loan settlement is offered is because the lenders look to recover at least some of the loan outstanding instead of nothing. 

But from the borrower’s perspective, this is not the best suitable option as it can negatively affect your credit report. Lenders view ‘settled’ as a negative remark questioning your repayment capabilities when you require another loan. Remember a settled remark can stay on your credit report for seven long years., thus making it hard to get a loan for seven years.

So, evaluate your financial situation carefully and opt for debt settlement only when you need it and there are no other alternatives available.