When utilized wisely, a loan can be a useful financial instrument to receive funding to satisfy your needs. To achieve most of our financial objectives, we plan, invest, and save. But at some moments in life, we can require money to pay for personal or professional commitments. It may be for your kids’ further education, an emergency, the urgent finance of a business venture, etc.
A short-term requirement for money could be a trip abroad, and a long-term need could be purchasing a home. However, the issue comes when we either don’t have enough assets or savings to liquidate them or we have no intention of selling them in order to raise money.
In these situations, we may need to take out a secured loan from a lender which is secured against collateral. Otherwise, we can apply for unsecured loans which are not collateralized.
Because life is uncertain, you can find yourself in a position where you are struggling to make loan payments on time. This might be the result of a financial crisis, a loss of business, a challenge, or a loss of employment.
Your lender may offer to “settle your loan” if you notify them of your incapacity to fulfill the repayment obligations. You could be unaware of or aware of the implications, but it sounds beneficial. Your credit score is adversely impacted by a debt settlement. It can hurt your prospects for future loans.
A Loan Settlement: What Is It?
Credit settlement, debt negotiation, and debt arbitration are other names for loan/debt settlement. This method involves reaching a mutual understanding between the creditor and lender when the borrower discloses that they are unable to repay the debt because of unexpected occurrences. The borrowing party makes a single, mutually agreed-upon payment to the financial institution for the final loan amount, which is lower than the total amount owed on the loan.
A loan settlement lowers your credit score, so you should only choose it if you have run out of other options for paying back the debt. Only debtors who can demonstrate true incapacity to repay the loan are eligible for the one-time settlement.
The total amount owed will be less than the amount that must be paid in full. If someone chooses to settle their loan, the entire agreed amount needs to be paid.
A person’s credit score will decline if they receive a loan settlement. Before being given the chance to settle their loan, borrowers must show their inability to repay the amount.
What Effects Does the Loan Settlement Have?
Let’s See with an Example
When Rahul, a Mumbai native, faced financial troubles, he took out two or three loans for his business. He struggled hard to make all of his EMI payments on schedule. Although he was able to pay off two of those debts. He was unable to make payments on the third. His bank eventually consented to settle his 50,000 rupee loan for just 40,000 rupees after a long period of time.
Rahul was relieved that the bank had granted him forgiveness and that he could no longer be responsible for repaying the debt.
After 2 years, Rahul’s situation improved, and his business had been doing well.
Once again, he asked for a loan from a different bank in order to fulfill an export order from another big client.
When he saw that the loan he had settled off just two years ago had negatively impacted his credit score, He became shocked. Furthermore, his loan was denied because of his poor credit score.
We are aware that Rahul is not exceptional in this; many people, whether knowingly or unintentionally, consent to settle a debt without fully understanding its consequences.
What Does CIBIL Stand For?
When you apply for credit cards or loans, your credit Information Bureau India Limited (CIBIL) score—a three-digit value of your credit score—determines your creditworthiness. A three-digit CIBIL score, which is determined based on your financial behavior, goes from 300 to 900.
As your CIBIL score approaches 900, there is a greater chance that you will be approved for a credit card or loan. A CIBIL score of 750 or more is regarded as good. It varies depending on your financial conduct.
How Does CIBIL Score Affect Loan Settlement?
When a financial institution or another lender decides to write off a loan, they will inform CIBIL. The reality that the borrower and the bank or lender have dissolved is not taken into consideration by CIBIL. Rather than calling the agreement a success, they call it settled. A loan term settlement is viewed as bad credit behavior, which results in a 75–100 point drop in the customer’s credit score.
The CIBIL has maintained this record for nearly seven years. As a result, it’s probable that the lending institutions will disapprove of the customer and attempt to avoid giving them any loans if they need one at that particular time.
Banking and other financial institutions look mostly at a borrower’s past repayment record before approving a loan. Finally, if the customer’s credit record shows the settlement, financing institutions and banks are unlikely to grant the loan.
What Role Does Banks/Lenders Play in Loan Settlement?
In cases where borrowers are truly experiencing challenges meeting their loan installments, banks or lenders may offer them a one-time settlement of the loan. After six months without any payments, you are given an option by your financial institution or the lender. Along with other similar considerations, they will assess things like losing one’s work, having an accident, or having a serious illness.
After meeting with the borrower, the lender or bank representatives evaluate his situation and the sincerity of his complaint before determining whether to write off the difference between the total amount paid and the amount owed. After that, the financial institution or lender reports a loss and frees the borrowing party of any liability.
Unawareness on the Part of Borrowers
Customers in difficulty who choose the one-time settlement option without realizing the effect on their credit score. They don’t know that it has a greater negative impact on your credit score than you may imagine. Since CIBIL will keep the record for those seven years, it might be challenging for the individual applying to get a loan during that period.
Solution for Borrowers
If you are borrowing and are experiencing difficulties returning your loan because of something like layoffs, an accident, or a major illness or injury, refuse to accept your lender’s or the banking institution’s initial proposal of the one-time settlement option. Remember that the settlement will result in a reduction in your credit score.
Alternatively, you could attempt to pay off the debt by selling off a section of your portfolio or a couple of your assets. If you are unwilling to do that, please contact your friends and relatives. Avoiding any kind of settlement is advised.
If all else fails and you have no other options, consider the settlement as your last recourse. However, you could discuss extending your payback period and receiving a shorter loan term with your financial institution or lender.
After you’ve made a choice with your financial institution or bank, ensure that you review your credit score and report to discover where you stand. Try to pay off all of your bills and use good credit behavior after you become aware of your credit score. This will improve your credit score over the next 12 to 24 months.
How to Raise Your CIBIL Score After a Loan Settlement
Here are Some Strategies to Raise Your Post-Settlement CIBIL Score:
- Make Sure You Receive the NOC: Make sure you get the NOC after the card has been deactivated. The NOC certifies that you are a credit-worthy cardholder with no outstanding balances with the bank.
- Handle the Credit Card Wisely: It’s critical that each month the credit card be utilized wisely. You can utilize as much as 40% of your credit limit each month. In this manner, unpaid invoices might be settled.
- It’s Important to Apply for the Right Kind of Loan: There are two types of loans available: secured and unsecured. Although unsecured loans are utilized for depreciating assets, secured loans are intended to stabilize asset purchases.
- Take Advantage of Credit Cards: Using credit cards is necessary to raise your credit score. If the credit card is not utilized, the lack of use could result in a decline in credit score. It’s critical that the entire balance be paid each month.
- Don’t Ask Questions or Apply for Loans Frequently: It’s crucial that you wait to apply for another loan after one has closed. The credit score will decline as a result of any loan rejections.
- The credit limit should be more than fifty percent. The credit score is influenced by the available credit on the credit cards. It’s crucial that the credit card’s available limit—which is greater than 50%—be kept unused.
- Clearing Outstanding Debts: It’s necessary that all outstanding balances have been paid in full and on schedule. The credit score will decrease for any past-due payments.
- It is necessary to change the account status to closed. The account needs to be changed from active to closed status when the loan has been paid off. This proves that all debts have been paid off.
The Approaches that are Frequently Taken When Repaying a Loan are as Follows:
The borrower notifies the lender of an unexpected event that will prevent him or her from repaying the debt. Once the lender has confirmed that the claims are authentic, it presents a one-time settlement alternative if it is convinced.
After determining the borrower’s ability to pay back the financial obligation and the seriousness of the matter, a mutually beneficial settlement sum (amounting to less than the remaining debt amount) is determined.
The borrower repays the entire settlement amount in one payment after deducting the interest and penalty.
The lending institution “writes off” the loan after the payment and other requirements are fulfilled. The loan account is then canceled and reported to the credit agency.
The Differences Between Loan Closure and Settlement
Despite the frequent confusion between loan closure and settlement, there is a significant distinction between both of these.
| LOAN CLOSURE | LOAN SETTLEMENT |
| It defines the act of closing an existing loan account complying with timely and complete repayment of the loan by the person receiving it. | When a borrower lacks the ability to pay back a loan, this approach involves paying off the lender with a sum that is less than the remaining balance.
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| Shows how creditworthy you are. | Suggestive of bad credit practices. |
| The lender is not required to accept less in order to reduce its risk. | In order to lower additional loan risks, the lender “writes off” the loan. |
| Having a solid repayment history raises your credit score. | Significantly lowers your credit score. |
| Beneficial for taking additional loans. | Hampers your ability to get loans in the future.
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How Can One Stay Out of the Debt Trap?
The use of a credit facility and the repayment that comes next call for responsible credit behavior. Due to the reasons it is always recommended that
- Borrow no more than your ability to repay.
- Always be prepared for the possibility of default by keeping emergency money on hand.
- Close and repay debts with diligence.
- Make responsible use of credit cards, personal loans, and buy-now-pay-later plans.
- If your credit score falls, keep an eye on it and take steps to raise it.
- Your credit score declines if you choose to settle your loan. Hold off on applying for another loan right now. Hold off till your credit becomes better.