What Is Loan Settlement? How Does It Affect Your Credit Score?
Loan settlement is often mistaken for loan closure. However, they are two different terms, impacting the credit score differently. If you make your monthly payments regularly and on time over the period of your loan, the loan account will be closed naturally once the loan is paid off. The same information is then sent to the credit rating companies, thus positively impacting your credit score.
On the other hand, a loan settlement occurs when the borrower fails to make repayments due to unavoidable circumstances. When this unnatural closure of a loan account is reported to the credit bureaus, it has a negative effect on the credit score, thus impacting the borrower’s ability to get approvals for future loans.
Read on to know more about loan settlement, its impact on your credit score, and how you can avoid it.
How Does Loan Settlement Work?
- The lender verifies and confirms that the defaults are due to a genuine reason that is beyond the control of the borrower.
- Once the information is confirmed, the lender offers a one-time settlement option. The lender agrees to settle the loan in a single payment (lower than the outstanding loan amount), writing off the interest and penalties. The settlement amount is decided after assessing the borrower’s repayment capacity and the severity of the situation.
- Once the debtor makes the loan settlement payment, the lender writes off the loan, closes the loan account and reports it as “settled” to the credit bureaus.
Impact of Loan Settlement on Your Credit Score
If you accept the one-time loan settlement offer and pay the settlement amount, the lender closes the loan account and reports your account as “settled” to the credit bureaus. The settled account is not a normal closure of the loan account. Hence, it is considered a negative event and reflects badly on your credit behaviour.
A settled account easily knocks off 75 to 100 points from your credit score, making it difficult for you to get approvals on future loans for the next seven years.
How to avoid a loan settlement? What are the alternatives?
A loan settlement may seem like an attractive option (reduced repayment amount), but accepting the offer may not be a wise financial decision (negative impact on the credit score). In fact, accepting a loan settlement offer should be your last option.
If you find it difficult to make repayment each month, look for alternative financing options.
Consider using these options before you decide to accept a loan settlement offer:
- Use your savings and investments
- Borrow money from family and friends
- Negotiate with your lender to restructure your loan, reduce the interest rate or extend the repayment tenure
- Take a low-interest personal loan to repay the outstanding amount in full
From the borrower’s perspective, a loan settlement is not the best option because it negatively impacts your credit score.
So evaluate all your options before you proceed to get your loan account settled.