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What Is Loan Settlement? How Does it Work?

Loan settlement is a phrase that is frequently mistaken for loan closure. Loan closure is an automatic process that occurs at the end of the tenure. If you opt for a Personal Loan at a predetermined interest rate, you repay it through monthly instalments. The loan is paid out gradually as the instalments are paid off. Once the entire amount is paid, the loan account is closed. This procedure is called a loan closure. Loan settlement, as opposed to this, is a forced procedure attempted when a borrower cannot pay off the loan amount.

What is Loan Settlement?

A borrower may be unable to repay the loan due to illness, job loss, or other reasons. The lending institution may allow the borrower to begin repayments after some time. The lending institution can also offer a one-time settlement option to borrowers. Loan settlement refers to a borrower’s agreement with a financial institution to “settle” the loan. The borrower only pays part of the outstanding loan amount. This process is also known as a Personal Loan defaulter settlement. 

In this, the financial institution waives a small part of the debt to make it easier for the borrower to settle the loan. In such cases, the loan status is marked as “settled” instead of “closed.”

Example – Mr X takes a Personal Loan of ₹1 Lakh for six years. He fulfilled personal loan eligibility and got the loan. The rate of interest is 10.30%. Mr X pays a monthly instalment amount of ₹1868 for four years. However, due to unavoidable circumstances, Mr X cannot make the payments after four years. He approaches the lending institution with a request to settle the loan. The lending institution assesses the situation and agrees to settle the loan. Mr X has to make a one-time payment to “settle” the loan.

How does Loan Settlement work?

Personal Loans are usually collateral-free loans. Unlike education or home loans, these are not guaranteed by a family member or friend. Hence, it is feasible to negotiate with the lending institution to settle the loan. After informing them about your inability to repay the loan, the lending institution will investigate the same. And if your reasons for non-payment are genuine, you can opt for settlement. 

You can be asked to continue payments after some time. The lending institution may offer a one-time settlement amount to be paid upfront. Negotiate the settlement amount with the lending institution to the best of your ability. The settlement amount is agreed upon depending on the debtor’s capacity for repayment and their situation. 

The lending institution writes off the interest and penalties to reach an optimal settlement offer. The debtor must accept the loan settlement offer and make the required payment. Following the repayment, the lending institution writes off the loan and closes the account. After that, the credit bureaus receive a “settled” report from the lending institution.

Impact of Loan Settlements

While loan settlements may seem like a good way for borrowers to gain some breathing space, the reality is not so. Loan settlements negatively affect a borrower’s credit score, and credit bureaus consider settled loans a negative point. When a loan is settled, the debtor’s CIBIL score is reduced by a few points. For the ensuing seven years, the debtor’s credit score will decline by 75 to 100 points.  Because of the low CIBIL score, no lending institution will lend money to a borrower during this period.

Also Read: Why Take A Personal Loan To Boost My Credit History?

Loan settlements are an overall loss for lending institutions. It aids the borrower more than the lending institution. The borrower has to make a one-time payment. This payment is much lower than what they would have paid for during the entire loan tenure. In this manner, the lending institution loses money during the settlement process. Lending institutions agree to loan settlements only when it is the best-case scenario.

How to avoid loan settlement?

Given their negative impact, it is best to avoid loan settlements altogether. It should be the last option for any debtor as it significantly lowers the credit score. Financial institutions can reject new loan applications when debtors have a record of a single loan settlement. Debtors can first look into liquidating some of their assets to pay off the loan. Also, look for monetary assistance from family to avoid loan settlement. The financial institution in question can be approached to extend the repayment period or to waive the interest for a certain period. The debtor can also offer something they own as collateral against loan payment. The main aim is to avoid defaulting and being marked as having bad credit behaviour.

Another option is to opt for a Personal Loan balance transfer. This process enables a borrower to transfer the total outstanding Personal Loan amount from one provider to another. The debtor may be able to secure a lower interest rate from the new financial institution. A Personal Loan balance transfer will not create a bad credit score for debtors if they opt for it.

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