General

How Will Debt Settlement Affect My Credit Score?

Whenever you take a loan, you plan on your repayment for an estimated period. However, sometimes, you may be unable to meet the repayment plan and commitment. You may find the need to approach your bank or lending institution in the hope that they offer you a One Time Settlement or debt settlement option. However, availing such an option can do more damage to your credit score as compared to remediating it.

Debt settlement is often mistaken for the closure of loan, but they are not the same. If you repay your monthly instalments on time, the lender will close the loan account. This is known as ‘loan closure’. This information is passed on to credit rating agencies and it will most likely have a positive impact on your credit score since you have paid off the loan successfully.

Read on to find out more about loan settlement and how it can result in a low credit score.

What is Loan settlement?

Let’s assume a scenario that you have taken a loan from a reputed lending institution. You may be unable to make timely loan repayments due to genuine reasons such as illness, job loss, or a financial crisis. In such a case, you will reach out to the lender and explain your situation. You may then request them to provide a time extension for making loan repayments.

The lender offers you a one-time settlement option which allows you to take some time off and settle the loan in a single payment at the end of such time off. Since you have some time on hand, you will accept this offer. Once you settle the loan payment in one go, the loan status is changed to ‘settled’ in your credit report. To understand more about credit reports and what all is included in them, check out CreditMantri, your go-to-source for all credit score related information in India. Let’s now understand what such a ‘settled’ status would mean.

Effect of ‘Settled’ Status

If you can convince the lender about your reason for non-payment, you may be offered a 6-month moratorium or non-payment period. This option is generally offered only in case of an agreement to make one payment later. The lender may write-off some amount to make it easier for the borrower to make loan settlement. Depending on the severity of the scenario faced by the borrower and the repayment capabilities, the write-off amount may differ.

Since the new agreed amount is lesser than the actual outstanding amount, the status of the loan is marked as ‘settled’. If the borrower pays the entire outstanding balance; the status of the loan can be changed to ‘closed’.

Effect of Loan Settlement on Credit Score

As soon as a lender provides a loan write-off option to a borrower, credit rating agencies are informed of the same. While the loan transaction ends as soon as loan settlement is done, it cannot be termed as closure. Thus, credit rating agencies refer to this as ‘settled’, to indicate to other lenders about a possible negative credit behaviour. This results in the borrower’s credit score getting impacted negatively.

Additionally, these agencies retain any such information for approximately seven years. If the borrower applies for a fresh loan during such a period, lenders may become sceptical about the repayment capability of the borrower. Sometimes, lenders may also reject the loan application.

What can a Borrower Do?

Borrowers consider loan write-off as an opportunity to reduce the burden coming from the loan account. However, borrowers may miss considering the negative consequences of this kind of settlement. A single step like this can have an impact on borrowers for nearly seven years i.e. till the time credit rating agencies retain the information about loan settlement.

It makes sense for borrowers to avoid getting swayed by the loan settlement option provided by lenders. Instead, choose to liquidate some of your savings or investments for paying off any outstanding loan amount.  Try out other methods of raising money to close the loan account. Loan settlement should be kept as the last resort by borrowers.

You can also try requesting the lending agency to provide an extension on your repayment term. Re-evaluating monthly instalment structure is another alternative to ease out monthly payments and reduce the interest burden in some way. After agreeing with the lender, ensure that you verify the changes that impact your credit report and credit score. Work towards a good credit score and try to improvise if there has been a negative impact.

You can opt for a secured loan instead of an unsecured one to avoid such situations. This way, the lender does not have to worry about your repayment capabilities. Alternatively, you can buy an insurance policy against the loan. Thus, even if there is a tough situation and you are unable to repay, the insurance can come to your rescue. This will also make sure that you do not default and your credit score remains unaffected.

Things to Remember

  • Always borrow as per your repayment capability and only for your requirement.
  • Do not borrow more than needed since it can make matters difficult at the time of repaying.

The primary reason why a one-time settlement is offered is that the lender can be sure that if you are unable to repay the loan; the lender can close the transaction with the amount that you can pay. While the lender still gets a portion of the due amount, your credit score gets negatively impacted with a status of ‘settled’. You will also find it hard to borrow in the future.

Conclusion:

Debt settlement may sound like a tempting option to borrowers who are facing financial difficulties, however, it requires a lot of thought and careful consideration. Depending on the specific situation of the borrower, it makes sense to reconsider the available options before choosing a debt settlement. This will help in keeping the credit score stable and future borrowing becomes easy.