Will a Loan Settlement Ruin My CIBIL Score?

Most credit users tell new borrowers two important things.  

• First, do not borrow more than you can easily repay. 
• Second, negotiate hard with lenders and try to avail yourself of the lowest interest rate possible.  

Both these suggestions help make repayment easier. Unfortunately, life does not always go as planned. It throws us curveballs and sometimes, we are just not prepared. An illness can happen anytime, and so does a family emergency. So how should one manage their loan commitments when they are dealing with a financial emergency? What is loan settlement and how does it impact your CIBIL score? Read on to know. 

What is Loan Settlement?

Most borrowers confuse loan settlement with loan closure. However, the two are not the same. Loan closure is when you pay all your EMIs on time, as per the amortization schedule provided to you by your lender. In other words, a loan is considered closed when a borrower has repaid both the principal and interest component of the loan as per the details mentioned in the loan agreement. 

Loan settlement refers to the process of closing a loan earlier than the stipulated period due to a financial emergency that has made it impossible for the borrower to honour the commitment they had made to the lender at the time of the loan agreement. For instance, let’s assume a borrower finds out they are suffering from an illness that would make it impossible for them to work for some time. In this case, the lender understands that the borrower is dealing with a genuine issue. Therefore, they will allow the borrower to take some time off from paying EMIs on the condition that once this EMI holiday is over, they will clear the entire loan amount in one go. This is known as credit settlement. 

In this case, since the lender knows that the borrower is incapable of clearing the entire amount due, they will write off some amount. The amount that is written off usually depends on the severity of the situation that the borrower is dealing with. Once the borrower pays the loan amount left after removing the written-off amount, the loan is considered settled.  

So, when a borrower pays the entire amount as per the schedule provided to them, the loan is considered closed. However, when a borrower pays a part of the loan amount and the lender writes off the remaining amount, the loan is considered settled. 

Let us now understand how both these events affect a borrower’s credit score. 

What is CIBIL Score and How Does a Loan Settlement Affect Your CIBIL Score?

The CIBIL score is a three-digit number between 300 and 900 that indicates a borrower’s creditworthiness and repayment capacity. The higher a person’s CIBIL score, the better their chances of getting approved for a Housing Loan and receiving beneficial terms and conditions on it. The CIBIL score is calculated based on various factors, such as the borrower’s repayment history, the age of their credit history, credit exposure and hard enquiries, etc. So, how does a loan closure affect a person’s credit score?  

When a person pays off their loan as per the schedule provided to them, it reflects positively on their CIBIL score. In this case, their CIBIL score grows. On the other hand, when a borrower settles a loan, the first thing that a lender does is inform credit rating agencies of this development. Credit rating agencies do not see loan settlement as ideal behaviour and therefore, when a borrower settles their loan, their CIBIL score immediately goes down. A borrower can expect to see their CIBIL score drop by 75 to 100 points after loan settlement. Further, the information that a borrower settled a loan stays on their credit report for 7 years and this information may stop other lenders from lending money to the borrower in future. 

Many borrowers see credit settlement as a way to save money and become debt-free sooner than they had anticipated. However, they do not understand the repercussions of such a decision – the loan foreclosure effect on CIBIL is hard to deal with in the long run. A loan settlement not only affects a borrower’s credit score but also affects their ability to avail of a loan in future. Thus, borrowers must try their best to not settle loans. If you are dealing with a financial emergency, consider liquidating your savings or other assets to take care of your EMI commitments. However, close the loan only when absolutely necessary. 

Also Read: Does Settlement of an Education Loan Impact the CIBIL Score? 

How to Improve Your CIBIL Score after Loan Settlement?

How to improve CIBIL score after settlement – this is an important question that many borrowers ask. Credit users must know that while they can take steps to improve CIBIL scores, they cannot get the information removed from their credit reports. Let us share with you some tips that will help you improve your CIBIL score after settlement.   

If your CIBIL score has taken a hit due to a loan settlement, the first thing you must do is to make it a point to not miss EMIs and credit card due dates. If you tend to forget, set up auto payments and reminders. This will certainly help. 

The next thing you must do is never exhaust your credit card’s limit. Borrowers see this as reckless spending behaviour and they do not take kindly to it. Maintain a credit utilization ratio of 30% or below. Similarly, credit rating agencies also do not assign good CIBIL scores to individuals who pay only the minimum amount due on their credit card each month. 

Do not apply for a new loan or credit card any time soon. A loan settlement will automatically reduce your credit score and a loan rejection, which is what you will face when you apply for a loan after settling another one, will reduce it further.   

Final Words

Following these tips will help you improve your CIBIL score after a loan settlement. However, a loan settlement will remain on your credit report for 7 years to come and reduce your chances of availing of another loan during this time. Borrowers must, therefore, opt for loan settlement only when they have no other option left. 

Also Read: Importance of CIBIL Score & Tips To Improve It