What is Loan Settlement? What does it do to your credit score?
When you apply for a loan, it’s important to know your loan repayment capacity. If you cannot repay your loan due to unavoidable circumstances, then one of the options available is loan settlement.
However, this is not a recommended option for various reasons, one of which includes the adverse impact on your credit score.
Often, a loan settlement is mistakenly confused with a loan closing. They are two separate terms that have different credit scores. The loan account will automatically close if you pay your monthly payment on time and regularly throughout the term of the loan. This information is sent to credit rating agencies, positively impacting your credit score.
A loan settlement is when the borrower defaults on repayments because of unavoidable circumstances. The credit bureaus report an unnatural closing of a loan account. This can harm the borrower’s credit score and affect their ability to obtain future loans.
Please continue reading to learn more about loan settlement and its effect on credit scores.
How does loan settlement work?
- Lenders verify and confirm that defaults are not due to the borrower’s fault.
- After the information has been confirmed, the lender will offer a one-time settlement option. The lender will settle the loan with one payment, less than the remaining loan amount. Penalties and interests are also written off. After assessing the borrower’s ability to repay and the severity of their situation, the lender will decide the settlement amount.
- After the debtor has made the loan settlement payment, the lender will write off the loan and close the account. The credit bureaus will report it as “settled”.
Credit Score Impact of Loan Settlement
The lender will close the account and report your account as “settled” to the credit bureaus by accepting the offer to settle the loan and paying the amount in full. The settlement account does not represent a normal closing of the loan account. It is a negative event that can reflect badly on your credit behaviour.
A settled account can easily reduce your credit score by 75 to 100 points. This will make it more difficult to obtain approvals for future loans over the next seven-year.
How can I avoid loan settlements? What are the options?
Although a loan settlement might seem appealing (lower repayment amount), it may not be the best financial decision. It could harm your credit score. Accepting a loan settlement offer should not be your last resort.
You may be unable to pay your monthly repayments. Consider other financing options.
Before you accept a loan settlement offer, consider these options:
- Save your money and invest in the future.
- Borrow money from friends and family
- Talk to your lender about restructuring your loan, lowering the interest rate, or extending the repayment term.
- You can take a personal loan with low interest to repay the entire amount.
From the borrower’s perspective, a loan settlement is not the best option as it negatively affects your credit score.
Before you decide to settle your loan account, evaluate all options.
