Understanding Loan Settlement and its impact on credit score

Before delving deeper into the topic, it is important to know the difference between loan settlement and loan closure.If you repay your loan in time through regular EMIs as agreed upon, then the lender will close your loan account without further questioning once all the EMIs have been paid. This process is known as loan closure. A successful loan closure positively impacts your credit score as you come across as someone capable of repaying a loan in time.But loan settlement is completely different from a loan closure and is not recommended in most circumstances.

If a borrower cannot pay off the loan, then the lender may offer the individual to make a one-time payment to settle the loan account. The settlement amount is lower than the actual loan amount and is usually followed by a non-repayment period.Consider the following example to understand what is loan settlement and the plausible situation when it can be used.Chandan took a loan for a personal requirement to be repaid in five years. However, he lost his job two years after he took the loan. After being jobless for six months, he finally got a job but at a lower salary.He can’t afford to continue loan repayment with his present salary. Therefore, he approaches the lender for a settlement of the loan. After assessing his financial situation, the lender offers him a one-time settlement amount that he needs to pay.Chandan accepts the offer and pays the reduced amount toward the full and final loan settlement.

The loan settlement amount is at the discretion of the lender. The lender may offer different settlement amounts to borrowers depending on the loan amount taken, the amount repaid to date, the reasons the borrower seeks a settlement, etc.The lender will write off a portion of the loan amount to settle the loan if the borrower’s reason for non-repayment is genuine. Moreover, a lender only offers a loan settlement if the borrower agrees to pay the settlement amount in one payment. The lender may consider a 6-months non-repayment period in such cases.But the status of such loans is marked as ‘settled’ in the lender’s book of account instead of ‘closed’.

Loan disbursements and their subsequent repayment with interest are an important source of income for any lender. Therefore, every time a loan settlement agreement is reached, the lender’s bottom line may get affected.As a result, credit rating agencies consider loan settlement as a bad habit of the borrowers. Whenever a borrower manages to strike a loan settlement deal with the lender, the lender informs the case to the credit rating agencies like CIBIL. On receiving such information, the agency performs the following actions.

• The agency marks the transaction as ‘settled’, which other agencies view as well.
• The borrower is flagged as unsuitable or risky for credit, and the individual’s credit score drops.
• All the rating agencies keep the information in their records for the next seven years. Therefore, the borrower is unlikely to get another loan during this period as lenders may reject the person’s application considering him incapable of completing full loan repayment.

To begin with, consider loan settlement as a last resort. If possible, then analyse your savings and investments and see if you can pay off your loan with them. You can also consider alternative arrangements like

• Debt restructuring, where you transfer the loan to another loan with a lower interest rate.
• Pledging your assets, such as gold, real estate, etc., to take a secured loan at a lower interest.

If going for a settlement is inevitable, then consider the following points.

• Try to repay the loan as much as possible to narrow down the outstanding loan amount as well as the settlement amount.
• Avoid applying for a new loan or credit card after a one-time loan settlement. Applying for a new loan can further drag down your credit score. Thus, wait until your credit score is restored.

After discussing what is loan settlement , it must be clear by now that it should be avoided at all costs. A loan settlement is basically a lender’s way of telling you that you are an unreliable borrower whose loan book should be settled as early as possible.That's not the impression you would like to have on any lender. Therefore, it is advisable to manage your finances prudently to avoid such a situation. Consider taking a lower loan amount so that you can keep the EMIs at manageable levels. Try to make provisions for an emergency.Eventually, always aim for loan closure instead of loan settlement.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.