The short answer is: settling your debts hurts your credit score and is likely to bring it down. How much your score drops depends on several factors like the size of your outstanding debt, whether you pay your other debts on time, how much the lender agrees to settle the debt for, and several other variables. 

To know more about the negative impact of debt settlement on your credit score, continue reading this handy article from the experts at CreditMantri. 

First things first, 

What is debt settlement?

Debt settlement is an agreement between the lender and the borrower for a one-time payment of an outstanding debt. Let’s say that you’re facing a financial crisis and unable to repay your personal loan EMIs on time. Instead of letting the loan be declared as an NPA (Non-Performing Asset), you negotiate with the lender and agree to settle the debt. In debt settlement, the borrower pays a partial amount of the outstanding loan balance. The debt is declared as “settled” instead of “closed.” 

In debt settlement, the borrower is freed of his/her outstanding debt. On the other hand, the lender receives at least a portion of the unpaid balance instead of nothing. It may seem like a win-win situation for both. But, the reality is that debt settlements cause adverse effects on the credit score of the borrower. 

How does debt settlement work? 

When we borrow any loan, our primary objective is to repay it fully and on-time. But, there may be unexpected financial situations where it may not be possible to repay loan EMIs. In such scenarios, the borrower and lender come to an agreement. This agreement is known as debt settlement. 

In debt settlement, the borrower pays a lower lump sum instead of the total loan balance. The lender agrees to the lower sum, as they consider recovering something is better than nothing. 

Here’s an example to illustrate debt settlement. Let’s say you owe Bank A Rs. 10 lakhs on a personal loan. Due to unexpected financial situations – a job loss, death in the family, etc. – you’re unable to repay the amount. You and your lender enter an agreement to settle the debt for a one-time payment of Rs. 4 lakhs. 

Why does debt settlement negatively impact your credit score? 

At the outset, debt settlement may seem like a good thing for the borrower. After all, aren’t you settling the loan obligation by providing the lender with a partial amount of the loan balance? 

Well, the truth is that your credit scores are the healthiest when you pay your debts on time and as per the original loan agreement. When you settle a debt, you do not honour the original debt agreement. Instead of paying the borrowed amount in full as per the loan terms and conditions, you’re paying your lender only a partial amount. 

This indicates that you have not honoured the loan agreement. So, when the lender agrees to settle the debt, your credit score takes a hit. This is also noted in your credit report. Future lenders can see the debt settlement record on your credit report, and it’s likely to impact your future loan eligibility. 

Settled is Better than Unpaid but Worse than Closed 

Your credit report contains detailed records of your financial history. It gives detailed descriptions of the loans you have availed of, your credit card dues, monthly EMIs, whether you pay them on time, and more. 

  • When you settle a debt, it’s reported as “settled” or “paid settled” on your credit report. 
  • When you repay a loan on time and pay it fully, it’s reported as “closed” or “paid in full” on your credit report. 
  • On the other hand, loans that aren’t repaid on time are noted as “unpaid” on your credit report. 

Remember that while the status “settled” is better than “unpaid,” it still impacts your credit score. Always aim to repay your debts in full so that they are reported as “closed.” 

Which debts should I settle? 

When it comes to credit score calculation, your payment history holds the most weightage. If you’re behind on multiple debts, it can be tricky to decide which debt to settle first. 

Generally, most lenders agree to a debt settlement only when they believe it cannot be brought current. Let’s say you have a personal loan 120 days late and a home loan EMI that’s 30 days late. Try to negotiate with your lender to settle the personal loan. You can then work on getting the other loan current. 

Remember that don’t try to settle a debt at the expense of delayed payments on other debts. Let’s clarify that statement with an example. For example, let’s assume that you have a car loan, a home loan, and a credit card. Your credit card bill is overdue and has crossed the 90-day mark. Do not try to settle that debt at the expense of delayed EMIs on your other loans. Having multiple delayed payments impacts your credit score more than having one delayed payment. 

How to rebuild my credit score after debt settlement? 

The credit score keeps changing based on your debts and other financial activities. If you have settled a debt and it has damaged your credit score, here are a few ways to rebuild it:

  • Ensure that you repay your loan EMIs, credit card dues, and other bills on time hereafter. Make use of the auto-debit feature offered by your bank so that you don’t miss out on payments. 
  • Try to stay within 30 – 40% of your overall credit limit. Keep tabs on your credit card and avoid overspending on it. 
  • Finally, monitor and track your credit score periodically to see if you’re on the right track. You can check your credit score for free within minutes by using CreditMantri. You can also get detailed credit reports to see if your credit history and score have progressed since debt settlement. 

Begin rebuilding your credit score after debt settlement by getting your free credit score from CreditMantri. 

Final Thoughts: Should you go for debt settlement or not? 

While debt settlement may seem like a great way to get rid of outstanding debt, it doesn’t bode well for your credit score and remains a black mark on your credit report. 

There’s no single answer. It all depends on your financial situation. If you’re facing a mountain of debt and you’re unable to repay them on time, then debt settlement is an excellent option. Use it to get free of your debts and take the right steps to rebuild your credit score. Though it may hurt your credit score, it’s still better than having an unpaid status on your credit report, which harms your score even more.

On the other hand, if you’re able to repay your debts on time or can arrange alternative funds to repay loan EMIs, then it’s highly recommended to avoid debt settlements, which can damage your credit score and remain on your credit report.