Loan Settlement in India: Meaning, Process & Credit Score Impact

Loan settlement is when a borrower facing financial struggles negotiates with a lender to repay a reduced amount instead of the full outstanding loan. While it offers you temporary relief, it will create a negative mark on your credit report, which can affect your borrowing capacity in the future.

This article will take you in-depth into how the loan settlement world works, its benefits and drawbacks, and what you should consider before going down this path. 

What is Loan Settlement?

A loan settlement occurs when the borrower can't repay the full amount due to financial difficulties. The borrower negotiates with a lender for a reduced amount that works for both parties. Once an agreement is made, the borrower pays the settled amount, and the lender writes off the remaining balance. After this payment, the loan will be marked as "settled" on the borrower's credit report. However, this can negatively affect one's credit score due to incomplete repayment.

A loan settlement can often be confused with a loan closure. Unlike a loan settlement, a loan closure means you have repaid your entire loan and cleared your EMIs. A loan that has been appropriately closed can result in a better credit score and history.  

How does a Loan Settlement Work?

Step 1: Firstly, evaluate your financial condition. Figure out how much you can pay as a lump sum from your income, existing debt, and expenses. 

Step 2: You will then have to contact your bank or financial institution and explain your inability to continue loan repayments due to economic issues, be it job loss, medical emergencies, or any other serious reason. You will also have to provide your supporting documents. 

Step 3: Once the lender finds your situation genuine, they will offer you a one-time settlement after a 6-month non-repayment period. You will then have to negotiate with the lender for a reduced amount that you can pay off, lower than your outstanding loan. 

Step 4: Once you and the borrower have agreed on a reduced amount, you should ask for a written agreement that mentions the settled amount, payment deadline, and how it will be reported to the credit bureaus. You shouldn't proceed without proper documentation. 

Step 5: Per the settlement terms, you must pay off the agreed amount as a lump sum. You must collect and keep proof of the payment.

Step 6: Your lender will then settle your account. Your credit report should show your status as “settled,” with no further dues listed. 

Benefits of Loan Settlement

• Less Debt: You can negotiate with the lender to repay a smaller portion of the original loan amount, significantly lowering your overall debt.
• Quicker Resolution: With a one-time payment, you can clear off your debt faster rather than struggling with the disadvantages of loan repayment for years.
• Avoids Bankruptcy: Loan settlement can help you avoid filing for bankruptcy, which has far more severe and long-lasting effects on your credit score.
• Reduced Stress:  Settling your debt can lower the constant pressure of missed payments and the risks of legal action by the lender.

Impacts of Loan Settlement on Your Credit Score

• Significant Drop in Credit Score: When a loan is marked as "settled" instead of "closed," your credit score can drop by 75 to 150 points or more. This is because it shows that you didn’t repay the agreed-upon amount.
  Record Stays on Your Report for 7 Years: The “settled” status remains visible on your credit report for up to 7 years, so even if your score improves, lenders can still see your past financial distress.
• Harder to Get New Loans or Credit Cards: With a “settled” mark, lenders may reject your future applications or approve them at higher interest rates and lower limits due to reduced trust in your repayment behaviour.
• Stricter Loan Processing and Verification: Even if you qualify for credit later, banks may conduct tighter background checks, ask for more documents, or even demand a guarantor or collateral.
• Risk to Job Opportunities: Employers in sectors like banking or civil services may check your credit report. A “settled” loan could hurt your chances of getting hired or promoted.

How to Manage Loan Settlement Challenges?

Managing the challenges of a loan settlement requires careful planning and smart decision-making. These are some key steps to help you minimise the damage and stay financially secure:

• Before opting for loan settlement, you will have to negotiate with your lender to extend your loan tenure or reduce your EMI. This will help you manage repayments without hurting your credit score.
• You can request the lender for a lower interest rate or temporary interest waivers as alternatives, as they may accept these if you show genuine financial hardship.
• Rebuild your credit score by paying other debts on time and avoiding defaults.
• If a settlement is necessary, you must get a written agreement, including all the required details. Avoid verbal promises, as they aren't legal proof and are difficult to prove in court. 
• Make the lump-sum payment on time and keep proof, such as receipts or bank statements, to protect yourself from future disputes.
• Once you've settled your loan, you must check your credit report to confirm that it is marked as “settled” and that no dues remain.
• You should get a secured loan or insurance for financial protection and avoid settlements.

What to Consider Before Settling a Loan?

Settling a loan can offer short-term relief, but it comes with long-term consequences. Before taking this step, you should keep it in mind to protect your financial future:

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

While loan settlement can offer quick relief from debt and late EMI payments, it should only be considered a last resort. It can leave a lasting impact on your credit score and financial credibility. Before settling a loan, make a well-informed decision by exploring all repayment options and choosing what best supports your long-term financial health.

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