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Loan Settlement and Its Effects on Your Credit Score

Updated on: Jun 28th, 2022


7 min read

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‘Loan settlement’ is a term that is often mistaken for ‘loan closure’. However, they are not the same. If you pay off all your monthly instalments on time and complete repayments as scheduled, the lender will close the loan account; this is termed as ‘loan closure’. 

The same information will be sent to credit rating agencies and it may have a positive impact on your score as you have successfully paid the loan off. Read on to know how the above scenario is different from loan settlement and its effects on your credit score.

What does loan settlement mean?

The meaning of loan settlement is explained with a scenario where you have taken a loan from a lender. Now, you are genuinely unable to make repayments due to an illness, injury, job loss, or some other reason. In this case, you inform the lender of your situation and request them to give you some time off before you begin repayments. 

The lender may give you a one-time settlement option where you take some time off and then, settle the loan in one go. Since you are given some time, you may readily accept this offer. Upon settling the loan in one go later, the status of this loan will be recorded as ‘settled’ in the credit report.

How does a lender process this?

If the lender is convinced that your reason for non-payment is genuine, he may consider offering a 6-month non-repayment period. This option will be offered only if you agree to settle the loan in one payment. The lender will write off a certain amount so that it is easier for the borrower to settle up the loan.

The amount that will be written off depends on the severity of the scenario and the repayment capabilities of the borrower. Due to this agreement for an amount lower than the actual outstanding amount, the status of the loan will be marked ‘settled’. In contrast, if the borrower had paid the outstanding balance completely, the status of the loan would be recorded as ‘closed’.

How does loan settlement impact your credit score?

Whenever a lender decides to write off a loan, he immediately informs the case to CIBIL and other rating agencies. Though the loan transaction comes to an end in the form of settlement, it is still not a usual closure. Therefore, credit rating agencies term the transaction as ‘settled’ making other lenders view it as a negative credit behaviour.

In turn, the borrower’s credit score drops. In addition, these agencies hold on to this information for about seven years. If the borrower wishes to take another loan during this period, lenders may get wary of the repayment capability of the borrower. There are possibilities for lenders to reject the loan application as well.

How can borrowers deal with this?

Borrowers see the loan write-off as an opportunity to pay less for the closure of the loan account. However, most borrowers are not aware of the inner calculations and consequences of such a settlement. One wrong step may bother borrowers for about seven years i.e. as long as credit rating agencies hold the information in their repository. Until and unless you don’t have a bother option, do not get swayed by the one-time loan settlement option offered by lenders. 

If possible, choose to liquidate your savings or investments to pay off the outstanding loan amount in full. Think of any other possible methods to raise money enough to close the loan account. It is recommended to consider ‘settlement’ as the last resort. In addition, you can try requesting the lender to extend your repayment term, re-evaluate the monthly instalment structure so it is easier for you to make monthly payments, reduce the interest rate, or at least waive off the interest for as long as possible. 

Once you strike a deal with the lender, make sure to verify the changes that happen on your credit report and credit score. Maintain a good credit score and behaviour, and try to make up for any dip in your score. To further avoid such situations, you can go for a secured loan rather than an unsecured one so the lender will not have to be wary of your repayment capabilities. 

Alternatively, you can also take an insurance policy against the loan. In this case, even if you come across a tough situation where you cannot repay, the insurance does the needful for you. Therefore, you will not default on payments and it won’t affect your credit score.

What you should remember?

  • Borrow within your repayment capability and as per your requirement. Do not get greedy and borrow more as you will find it difficult when repaying.
  • The main reason why a one-time settlement option is provided is that the lender will be sure that you are unable to repay the loan; they would want to close the transaction with whatever you can pay. So, they would want to finish the deal with whatever they can get from you.
  • Your credit score will drop considerably with a status of ‘settled’. This will make it hard for you to get any loans in the future.

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