Debt Settlement and its Impact on Your Credit Health

If you have been struggling to pay off your debts and cannot seem to find a way to pay off your dues, you might consider requesting your lender for a ‘debt settlement’. It is an arrangement wherein the lender allows you to pay off a portion of your total dues and the remaining dues are forgiven. While debt settlement may be a sensible last resort, especially if you are continuously incurring high interest, it stays on your credit report for many years and severely impacts your score.

To help you decide, here is a complete guide on what debt settlement is, how it works and how it would impact you. However, before opting for a settlement, you must monitor your credit health on platforms like Paisabazaar to see where your credit situation stands currently and how badly it may be impacted so that you can plan your finances accordingly.

What is Debt Settlement?

Debt settlement is the process through which the borrower can request the lender to settle the loan by paying a portion of the amount borrowed in lump sum. Borrowers can negotiate the terms of loan settlement on their own or even hire third party to do it on their behalf. If you hire a company for this, you will have to pay a fee or even a portion of your savings. So, you must consider the additional costs that you may have to pay even if you get a concession on your loan repayment.

While finalising the debt adjustment, you may agree upon a reduced outstanding amount to be paid as a one-time final payment, debt discharge or lower monthly instalments. The final decision to accept the request for settlement and its terms are solely based on the lender.

Risks to Keep in Mind While Opting for Debt Settlement

Though debt settlement may be the last resort in case you cannot afford to pay your debts, you must consider the risks associated with it, as shown below:

Damaged Credit Score: Since, you usually stop making the repayments once you initiate the settlement process, the missed payments can be marked as delinquencies. Along with the non-payment of the instalments, the overdue loan amount and the late payment fees together increase your credit utilisation ratios as well. Thus, the damaged payment history and high credit use negatively impact your credit score. Moreover, whenever any loan account is settled, instead of paid, the credit score of the borrower takes a serious hit and drops down significantly. It is believed that this affected credit score can take up to 7 years to recover.

Long Drawn Process: The process of debt settlement is quite long and requires a lot of patience and negotiating. Once you submit your request for debt relief, this process may also take years to come to a conclusion. During this time, you must also collect enough savings to be able to pay the lump-sum loan settlement amount that your lenders may agree upon.

Additional Charges: Debt settlement comes with its own additional fees and charges which can add-on to the final amount you have to pay after finalising the terms and conditions of debt relief, thus increasing the final cost. For instance, if during the discussion regarding the settlement you had stopped making your monthly payments, then those payments can accrue interest over time, along with late fees and other charges. In addition to this, if you had hired a debt settlement company to represent you, then it also charges you a significant fraction of your settlement as its fee.

Tax on Forgiven Loan: Loan settlement may reduce the amount you have to repay to your creditors, but the remaining loan amount may fall under taxable income. This, in turn, may increase the total tax you have to pay at the end of the financial year.

When Does It Make Sense to Settle a Debt?

It is generally advised to opt for debt settlement as one of the last resorts if you are unable to repay your loan according to the initial repayment plan. You may consider or explore other alternative options, like balance transfer, debt consolidation, or even credit counselling for coming up with a better debt management plan, if you find yourself struggling with your debt.

If all these methods do not work or do not seem the right one for you after evaluation, then it is advised to choose the debt settlement option. But, it will depend on your circumstances and lender to decide whether to allow loan reduction and settlement or not. Nevertheless, you can always try any one of these alternatives and even switch your approach to become debt free if the chosen course of action is not giving positive results.