Personal loan settlement: How does it impact your credit score and report?

Sometimes, individuals come across situations that can drain their finances or lead to income stopping. For example, a major medical emergency, accident, etc., can lead to a huge hospital bill and drain personal finances. A situation like Covid led to many people losing their jobs, a pay cut, etc. During such situations, servicing personal loan EMIs can be difficult. Considering your borrower’s deteriorated financial situation, the bank may make a loan settlement offer. 

In this article, we will understand what is a personal loan settlement, its pros and cons, its impact on the credit score and report, and how to remove ‘settled’ status from the credit report.

What is a personal loan settlement?

A personal loan one-time settlement is a mutual agreement between the bank and the borrower. Considering the borrower’s deteriorated financial situation, the bank makes an offer to the borrower to repay a lower amount than what is outstanding, to which the borrower agrees.

For example, Dinesh had taken a personal loan of Rs. 2 lakhs for a tenure of 2 years. After six months, Dinesh met with a road accident and is disabled. On one side, the treatment has cost him lakhs of Rupees. On the other hand, due to his disability, he is unable to work and has lost his job. He is unable to pay the outstanding amount of Rs. 1.6 lakhs. After considering Dinesh’s financial hardships, the bank made a settlement offer of Rs. 1.2 lakhs, to which Dinesh has agreed.

A loan settlement is a negotiation process between the borrower and the bank. The borrower shares the proof of their difficult financial situation due to which they are unable to pay the loan EMIs. On evaluating the borrower’s circumstances, the bank may take a considerate view of the situation. After internal deliberations, the bank may offer a settlement wherein the borrower pays a lower amount than the outstanding.

The borrower has to pay the loan settlement amount in a lumpsum as it is a one-time settlement. The bank writes off the remaining amount. On receiving the amount, the bank closes the loan account in its books, and confirms the same to the borrower with the required documentation. A loan settlement is also known as a debt settlement.

The bank offers a settlement option in specified cases. Some of these can include a medical condition that has wiped out the borrower’s savings and investments, and left them in heavy debt. The borrower is disabled, unable to earn income, and has gone into debt. The borrower has lost their job, is unable to find another job for a considerable time and has no savings and investments to repay the debt.

Impact of loan settlement on credit score and report

Some borrowers may think a personal loan settlement is the same as closing the loan. However, from the credit report point of view, that is not the case. When the borrower settles the personal loan, the bank reports the same to the credit information companies.

The CIC updates the loan status to ‘settled’ and not ‘closed’ in the borrower’s credit report. The ‘settled’ status has a far-reaching impact on the borrower’s credit profile. A loan settlement is considered as a negative credit behaviour by the borrower. Hence, in the short term, the borrower’s credit score will fall sharply. The sharp fall is similar to what happens when a borrower delays or defaults on a loan repayment.

In the long run, the ‘settled’ status stays on the borrower’s credit report for up to seven years. The settled status will appear for this long period unless the borrower takes steps to get it removed. Till the time, the settled status reflects in the credit report, the borrower will find it difficult to get new loans and/or credit cards.

Financial institutions consider the ‘settled’ status as negative credit behaviour by the borrower. Hence, they will be sceptical of extending new credit (loans or credit cards) to such borrowers. Over a period of time, with good credit behaviour, the borrower’s credit score may recover. However, due to the settled status, the borrower will still find it difficult to get new credit in spite of a good credit score.

Thus, the settled status has short- and long-term repercussions on the borrower’s credit profile. Hence, the borrower must think through carefully before opting for a loan settlement. The borrower should consider a loan settlement as the last option on the table.

Pros and cons of a loan settlement

Some of the pros and cons of a loan settlement include the following. A loan settlement offers immediate debt relief to the borrower. Once the loan settlement is done, the borrower need not worry about follow ups from recovery agents or legal proceedings from the bank.

However, a loan settlement leads to a sharp fall in the borrower’s credit score in the short run. In the long run, the borrower will find it difficult to get any new loans or credit cards. For new loan applications, banks may insist on secured loans, and that too on higher interest rates.

Alternatives to loan settlement

Before considering the personal loan settlement option, check all other alternative options. Check with the bank whether they can offer a moratorium on the EMI payments until your financial situation improves. Ask the bank if they can restructure your loan with a longer tenure resulting in a lower EMI to match your cash flows. Speak to your family, relatives, friends, etc., if they can provide you with any financial help to repay the loan.

How to change the ‘settled’ status to ‘closed’?

If there are no alternatives, the borrower may go for a personal loan settlement as a last resort. However, as explained earlier, the settled status will reflect on the credit profile for up to seven years. Hence, you must try your best to get the ‘settled’ status changed to ‘closed’ status.

In future, once your financial status improves, you must approach the bank to repay the outstanding amount for the earlier settled personal loan. Once the bank agrees, you must pay and collect the ‘No Dues Certificate’ from the bank. The bank will report the loan repayment to the credit information company and update the ‘settled’ status to ‘closed’ status.

Should a borrower opt for personal loan settlement?

A personal loan settlement offers immediate debt relief to the borrower. However, it comes at a huge cost. Loan settlement results in a sharp drop in credit score, and the settled status stays on the credit report for a long time, making it difficult to get new credit. Hence, a borrower must always explore other alternatives first. If there is no other alternative, a personal loan settlement may be opted for as a last resort only.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.