Loan Settlement And Its Effects On Your Credit Score

People take all kinds of loans—personal, business or gold loans, to name just three—to meet immediate as well as long-term financial needs, when they are falling short on money.

But oftentimes, a borrower is unable to repay a loan owing to illness, injury, job loss or any other reason that may have left him or her insolvent. In such a situation, they may choose to go in for a loan settlement.

What Exactly Is A Loan Settlement?

A loan settlement is different from a loan closure, in which the loan is fully repaid along with the interest, and is therefore closed.

In a loan settlement, the borrower tells the lender that they are unable to repay the loan owing to difficult circumstances and asks the lender to give them some time off before they begin repayments.

The lender could give the borrower a one-time option of settling the loan in one go, after they have taken some time off. Once the repayments have been made, the status of the loan is considered to have been “settled.”

Lender’s Risk

A lender needs to be convinced that the borrower has a genuine need for a loan settlement. In such a case, the borrower may be given a non-repayment window of up to six months to settle the loan. Moreover, the lender may also write off a certain amount off the principal, so as to make it easier for the borrower repay the rest of the loan and interest.

The amount written off depends on the gravity of the situation that the borrower may be facing and his or her repayment capabilities. So, the loan will effectively be considered “settled” at an amount lower than the actual loan amount. The loan would have been considered “closed” had the borrower repaid the principal amount as well as the interest completely.

Impact on Credit Score

When a loan is “closed” the impact on the borrower’s credit score is positive, and as a result of that, the CIBIL score improves over time.

On the other hand, the moment a lender decides to write off a loan, credit information agencies are informed. Although the loan does come to an end, it has been “settled” and not “closed” and to that extent, it is seen as negative credit behaviour by the agencies and so, can have a negative bearing on one’s CIBIL score.

Put simply, a loan settlement can lead to a drop in one’s credit score. This information is held by such agencies for a period of seven years. If in that period, the borrower does wish to avail of another loan, the application may even be rejected if lenders are not sure of their capacity to repay.

Borrowers should, therefore, look at a loan closure only as an opportunity to pay less than the original amount, for the closure of the loan account. They should, however, be aware that a settlement will impact their credit history and could have long-term consequences.

Ideally, borrowers should try as much as possible to pay off the loan in full so that their credit history is not impacted. But if they must strike a settlement deal with the lender, they should make sure that they are aware of the way the same will impact their credit history.

To avoid any further drop in their credit scores, borrowers should go in for secured loans that are collateralised and in which, in case of a default, the lender can take over the pledged asset in lieu of the unpaid portion of the loan and interest.

Loan Settlement and Its Impact on Credit Score

Most of us need to take a loan at some point to fulfil immediate or long-term financial needs. This could be for education, medical emergency, buying a house or a vehicle, or any other requirement. We may be unable to repay it despite our best intentions and preparation. The reasons could vary from illness, injury, job loss, etc, leaving the borrower insolvent. They may choose to go in for a loan settlement in such a situation.

Loan Settlement Explained

While a loan closure means the principal amount and the interest have been paid in full and thus closed, in loan settlement, the borrower requests the lender for some time off before they can begin repaying again. The lender may give a one-time option of settling the loan after this break. Once the borrower makes the repayments, the loan’s status is considered “settled.”

The lender wants to know if the borrower really needs help resolving the debt. Sometimes what happens is a borrower can have six months of default on the loan. Also, the lender can decide to lower the size of the loan to help the borrower repay faster. Thus, the borrower has to pay only part of the loan, not the whole amount.

The lender looks at the seriousness or authenticity of the borrower’s situation and whether the loan can be repaid or not during settlement loans. Then, the amount of debt to be forgiven is decided. This means that borrowers only have to pay back a part of what they owe and not the whole amount. If everything was paid off, including interest, the debt would be completely gone.

The Impact of Loan Settlement on Credit Score

When a loan is paid off in full, it is considered "closed," which is good for your credit score and can improve it over time. Now this is what most borrows end up doing. However, a few borrows fail to do so and the lender may decide to forgive part of the loan.

When the lender decides to forgive part of the loan, it's called a "settlement," which isn't so good. The credit unions see this as a negative because it means the borrower hasn’t paid back all he owes. This can cause the borrower’s credit score to go down.

This settlement notice will remain on record for seven years. Meanwhile, if the borrower wants to take out another loan, the lender can say no because they don’t know the borrower’s ability to pay. Especially since they already know that they have failed to pay a loan in the past.

When borrowers settle a loan, they pay less than the original payment, which ends the loan. However, paying off only part of the debt can ruin their credit history and cause problems in the future.

Ideally, borrowers should repay the loan in full to keep their credit history intact. But if they fail, they need to understand how the settlement will affect their credit.

Borrowers can opt for a secured loan to avoid further credit rating reductions. These loans are backed by something valuable like gold, or a car or a house. In the event of default, the lender may seize the pledged property in lieu of the remaining loan balance.

How Does Loan Settlement Work

Settling a loan is a vital step for borrowers who need to close their debt. It involves repaying the loan entirely before its scheduled tenure ends. This process allows borrowers to fulfill their debt obligations sooner, potentially reducing interest costs. However, agreeing to a loan settlement may cause a temporary dip in your credit score. It's important to note that not all borrowers who struggle to repay a loan are automatically eligible for this process.

How can Borrowers Deal with The Problem

While paying off a debt by paying less than you owe may seem like a good idea, it’s important to think it through because it can have serious consequences. If everything else has been tried and this is your only last resort, it is best to consider paying the cost.

Here are some things you can try before agreeing to a debt settlement.

1. Use your savings to pay off debt or sell investments and other assets.

2. Borrow money from friends and family.

3. Consider getting a low-interest loan like a gold loan.

4. Negotiate with your lender to change the terms of your loan, such as reducing interest rates or extending repayment terms.

5. Make sure you insure your loan and pay your premiums on time. If you default on the loan, the insurer will pay for it.

Avoid Falling in Debt Trap

You need to be responsible for your money by using and paying off the loan. Here are some tips to remember:

1. Only borrow what you can afford.

2. Save some money for emergencies so that if something unexpected happens, you’ll still be covered.

3. Pay the loan on time, and try to complete the loan as soon as possible.

4. Use credit cards, personal loans, and Buy-Now-Pay-Later options wisely.

5. Check your credit score and if it’s low, work to improve it.

6. If you’re paying off a loan, wait until you improve credit score before applying for another one.

7. Be careful not to borrow money for things you don’t really need just because it seems like a good deal.

8. Focus on saving money by paying off debt so that you are prepared for any emergency by not incurring additional debt immediately.

Building Good Credit after Loan Settlement

The million dollar question is: How to improve CIBIL score after loan settlement?

While your loan payments will lower your monthly EMI payments, having a lower credit score can be a temporary problem.

If you want to take out a loan or get a credit card, it’s important to improve credit score.

However, if your credit score isn’t great right now, don’t worry. You can take control of your finances to improve your credit score. Here’s how:

1. Build a good credit history

Lenders look at your credit report before determining whether to give you a loan. So, it’s important to start building a good credit history. Make sure you pay all bills and loans timely to improve your credit score faster.

2. Change your account status from 'Settled' to 'Closed'.

Changing your account status from ‘Settled’ to ‘Closed’ with your credit card company is a simple way to improve your CIBIL score. To do this, you must pay all your debts in full.

A ‘settled’ status means you haven’t paid off the loan in full, which isn’t great for your credit score. If you can’t pay all your bills at once, talk to your bank or credit card issuer.

Try to agree on a specific amount you can manage and what your bank considers appropriate. Having a ‘closed’ status on your credit report will have a positive impact on others.

3. Pay your bills on time

Your payment history plays a big role in your credit score, accounting for about a third of it. Paying off all your loans and credit card bills on time and in full is one of the best ways to keep your credit score up.

Doing this will have an immediate and significant impact on your score. You may need to cut your debt to make sure you can pay all your bills, but it would be worth it to improve your credit score.

4. Settle any outstanding debts

Leaving any debt or credit card balance unpaid can really hurt your credit score. Even though it may be difficult at first, talk to each of your lenders and try to find a way to pay off everything you owe.

The longer you wait, the higher the interest rate, and you’ll end up paying more. Plus, the longer you procrastinate, the lower your credit score will continue to be. Missing a loan or credit card makes things worse. Paying them will help strengthen your credit score and get you approved for future loans.

5. Get a secure credit card

If you don’t already have a credit card, you should get one. Even if you’ve paid off debt, owning and responsibly using a credit card can improve your credit score, making it easier to borrow.

Buy with your credit card and make sure you pay the full amount by the due date. This will help you increase your credit score faster. If you can’t get a regular credit card, get a secured credit one with a fixed deposit.

You can start with a small deposit of around Rs 25,000-30,000. The credit card issuer will soon approve cards with a fixed 90% deposit.

6. Reduce your credit usage to less than 50%.

The amount of your credit limit you use also affects your credit score. Make sure you don’t spend more than half of the allowance. For example, if your credit card allows you to spend Rs 1 lakh. Try not to spend more than Rs 50,000 at any given time. Using more of your credit limit means you are relying more on credit, which can hurt your score. Aim to use only about half of what you are allowed to use.

7. Avoid applying for new loans

Avoid applying for or inquiring about another loan for months after the loan is settled. Being denied a loan can further lower your credit score. Focus on rebuilding your credit rather than getting more.

8. Use your credit card

Some people stop using their credit card in an attempt to improve their credit score, but that’s not a good idea. To keep your credit score high, you need to use your credit card responsibly. If you don’t use it at all, your score will drop. Another way to improve your score is to use only a fraction of your credit limit and pay it all off each month.

9. Choose the Right Type of Loan

The type of loan you get also affects your credit score. There are two types: safe and unsafe.

Things like houses are bought with secured loans and backed with something as valuable as the house itself. Unsecured debt, such as credit card bills, is unsecured.

Having more secured debt and less unsecured debt is better for your credit rating. A mix of 80% secured debt and 20% secured debt looks great and can help improve your credit score.

10. Use your credit cards wisely

Many people overspend on their credit cards without thinking about the consequences. This often results in a low credit score because they don’t know how to use their card properly.

To use your credit card wisely, try to spend only about 30-40% of your total credit card balance per month. This way you can manage your payments and avoid bankruptcy.

11. Always get an NOC from your credit card company

Make sure you get a No Objection Certificate (NOC) from your card issuer before closing any credit card account. Not having NOC can negatively affect your credit score.

Getting an NOC means you have settled all your debts responsibly and helps maintain your reputation as a good cardholder. Make sure you get the NOC within 45 days of closing the card.

Important Aspects of Loan/Debt Settlement

If you loan settlement is the last resort, remember it’s a crucial decision and has many key aspects to consider:

Impact on Credit Score: Loan settlement can damage your credit score for a long time, making it difficult to acquire future loans or credit cards with favourable terms.

Tax Implications: In some cases, the forgiven debt amount is considered taxable income by the government. Thus, you must consult an advisor before deciding to settle.

Negotiation Process: Negotiating a good settlement requires you to understand your financial situation, communicate effectively with the lender, and seek professional help to ensure it works out in your favour.

Alternatives: Explore alternatives like a loan modification before resorting to settlement, as the impact of these options may be less severe on your credit.

Conclusion

While a loan settlement does help in closing a loan account by repaying less than the amount that had been borrowed, it does have a negative impact on your CIBIL score.

Moreover, as a borrower you should also ensure that you always choose a reputed lender like IIFL Finance. Doing this will not only get you the best deal possible in terms of the interest rates and other costs, but also when it comes to repaying your loan. IIFL Finance makes the entire process—from application to repayment—a hassle-free affair for the borrower.

And if you must go in for a loan settlement, IIFL executives will help you in making the entire process as smooth and quick as possible.

FAQs

Q1. Can I pay off the previous loan and apply for a new loan? Is the cost reasonable? Will I see an improvement in my CIBIL score after loan settlement?

Yes, you can consider applying for another loan after you have repaid the previous one. However, it’s important to take a closer look at your financial situation and understand the impact it can have on your credit and overall financial health before moving forward. If you’re struggling to pay the full amount, paying off debt can be a sensible option, but it’s important to weigh the pros and cons and seek financial advice if necessary. While paying off debt may provide temporary relief, its impact on your CIBIL score may vary based on factors like your overall credit history and repayment habits

Q2. Will repaying the loan increase my CIBIL score?

Loan repayment can positively impact your CIBIL score. This reflects healthy financial practices and reduces the amount of outstanding debt, which can raise your credit score in the eyes of lenders. However, the extent to which your CIBIL score increases may vary depending on factors such as your credit utilization level, payment history and overall credit profile.

Q3. Does lump sum payment affect CIBIL credit score?

Yes, a one-time fix can affect your CIBIL credit score. While this may provide relief by allowing you to pay off the outstanding debt at a discounted rate, it also lets lenders know that you haven’t been able to pay the full amount according to the original terms, causing you distress your creditworthiness and can reduce your credit rating.

Q4. How long does a resolved loan stay on CIBIL credit report?

Loan repayments usually stay on your CIBIL credit report for seven years from the date of repayment. It can affect your creditworthiness at this point and affect your ability to get loans or loans from financial institutions.

Q5. What is the impact of credit card debt on my CIBIL score?

Credit card debt repayment can affect your CIBIL score similar to debt repayment. While this may provide temporary relief by allowing you to pay off the balance in exchange for a discount, it also lets lenders know that you have failed to meet your original repayment obligations. This can lower your credit rating and affect your creditworthiness in the eyes of lenders.