When dealing with debt, two commonly used terms are loan settlement and loan closure. While they may sound similar, they have distinct meanings and significantly different impacts on your financial health. Understanding the difference between these two options is crucial for making informed decisions about managing and closing your loans.
What Is Loan Settlement?
Loan settlement or debt settlement is a mechanism by which the borrower negotiates with the lender to pay an amount less than the outstanding loan. This often occurs when a borrower cannot pay back the loan in full because of financial constraints. Lenders would settle for the loan being paid back for less than its value rather than classifying it as a total loss.
How Does Loan Settlement Work?
Loan settlement is a multi-step process involving negotiation and agreement on the lowered payoff. Here’s the way the process usually goes:
Financial Distress & Default: The borrower is in financial trouble and cannot make the regular loan payments, resulting in defaults.
Communication with Lender: The borrower (or a loan settlement professional) contacts the lender to negotiate a settlement.
Negotiation Process: The lender assesses the borrower’s financial position and can settle for a lower settlement amount, usually 40-60% of the outstanding loan.
Conclusion of the Agreement: After both parties have reached an agreement on the settlement amount, the lender makes a formal settlement offer.
Payment & Loan Closure: The borrower settles the agreed settlement amount, and the lender regards the loan as closed.
What Is Loan Closure?
Loan closure is the payment of the entire loan amount, both interest and principal, according to the agreed-upon terms with the lender. The lender records the loan as ‘closed’ in the borrower’s account upon receipt of the full payment, thus having a positive effect on their credit score.
How Does Loan Closure Work?
Loan closure can happen through the following ways:
Monthly EMI Payments: The borrower repays all the monthly payments during the loan tenure.
Prepayment or Foreclosure: The borrower decides to pay the outstanding loan amount prior to the loan’s tenure to prepay the loan.
Final Clearance Certificate: After the loan is paid, the lender provides a No Objection Certificate (NOC) or loan closure certificate.
Credit Report Update: The lender reports the loan as ‘closed’ to credit bureaus, having a positive effect on the borrower’s credit history.
Key Differences Between Loan Settlement and Loan Closure
Aspect
Loan Settlement
Loan Closure
Definition
Negotiation to pay a lesser amount in lieu of the full outstanding balance
Full payment of the loan according to agreed terms
Impact on Credit Score
Negative impact; indicated as ‘settled’ in credit report
Positive impact; indicated as ‘closed’ in credit report
Loan Eligibility in Future
May result in difficulty in obtaining future loans
Enhances possibility of obtaining future loans
Process
Partial payment accepted through negotiation with lender
Complete repayment through EMIs or prepayment
Legal Implications
May escape legal action but does not necessarily ensure it
No legal issues
Tax Implications
Forgiven amount can be treated as taxable income
No tax obligations
Advantages and Disadvantages of Loan Settlement
Advantages:
Reduces financial burden through partial payment.
Avoids legal action from lenders.
Gives instant relief from recovery agents.
Disadvantages:
Adversely affects credit score.
Reduces future borrowing capacity.
Potential tax consequences on the forgiven sum.
Advantages and Disadvantages of Closing a Loan
Advantages:
Enhances credit rating and financial reputation.
Puts an end to future debt liabilities.
No legal or taxation complexities.
Disadvantages:
Needs to be repaid in full, which can be financially burdensome.
Prepayment penalties might be imposed in certain situations.
Which Alternative Should You Use?
The choice between loan settlement and loan closure is based on your financial circumstances:
Choose loan settlement when you are seriously in financial crisis and unable to repay the amount in full.
Choose loan closure when you can repay the full amount, since it is better for your long-term credit worthiness.
Last Words
Loan settlement and loan closure are two entirely disparate financial actions with opposite effects. While loan settlement may offer temporary convenience, it has long-term credit implications. Loan closure is the best solution for having good financial health and a good credit score. If you are in debt, take help from a financial advisor or debt resolution professional to find the best possible solution according to your requirements.