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What Is Loan Settlement? Here’s What You Should Know

If you think loan settlement is a positive development for your credit score and is the same as loan closure, then you are mistaken.  They are both different terms, that impact the credit score very differently. We will break this down and explain it better – when you pay your monthly EMIs regularly and on time, then your active loan will be closed naturally once the amount is paid off. The credit rating companies are then notified about this update, thereby positively impacting your credit score.

Whereas, a loan settlement occurs when the borrower fails to make repayments due to unavoidable and unforeseen circumstances – be it an emergency or due to lack of funds. When this unusual closure of an active loan is reported to the credit bureaus, it will have a negative effect on your credit score, thus impacting your ability to get approvals on future loan applications.

In this blog, we will highlight what loan settlement essentially is, how it can be avoided and it’s impact on your credit score.

How Does Loan Settlement Work?

The one-time settlement option is not offered to all defaulters. There is a certain process that all lenders follow to come to such a decision..

  • First and foremost, the lender needs to verify that the defaults are due to a genuine reason that is beyond the control of the borrower.
  • Once this is confirmed, the borrower is given a one-time settlement option. The lender agrees to settle the loan in a single payment, that is lower than the outstanding loan amount, writing off the interest and penalties. This settlement amount is decided after assessing the borrower’s repayment capacity and the severity of the situation.
  • Once the borrower makes this payment, the lender then closes the active loan and reports it as “settled” to the credit bureaus.

Impact of Loan Settlement on Your Credit Score

If you accept the offer and decide to ‘settle’ the loan, the lender will close your loan and report it as “settled” to the credit bureaus. But remember, 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.

How to avoid a loan settlement? What are the alternatives?

A loan settlement may seem like an attractive option at first due to the reduced repayment amount, but accepting the offer may not be a wise financial decision, considering the negative impact it will have on the credit score. In fact, accepting a loan settlement offer should be your last resort.

If you think you’d be unable to make timely repayments every month, we would recommend that you look for alternative financing options.

Consider these options before you decide to settle a loan, no matter how bad your situation is:

  • 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 one’s credit score, thereby making it difficult to avail another loan down the line. So remember to evaluate all your options before you decide to get your loan settled.

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