Do you fear low credit score? Keep away from one-time loan settlement

Private sector banks like Axis, Kotak Mahindra, and RBL have reported an increase in non-performing assets arising from unsecured loans, like credit cards and personal loans. Instead of panicking, here’s how individuals nearing default, or those who have already defaulted can deal with the situation.

Factors causing stress

The primary cause of stress among borrowers is over-leverage. “A person’s Equated Monthly Instalments (EMIs) should ideally not exceed 50 per cent of their net take-home income. If this happens, they will not be left with enough money to meet essential expenses,” says Arun Ramamurthy, director, Andromeda Sales and Distribution, and an expert in digital lending.

Many people are living beyond their means. “The YOLO (you only live once) philosophy has gained prominence while financial prudence has taken a back seat,” says Anshuman Panwar, co-founder, Creditas Solutions, a digital debt collection agency.

“Layoffs, especially in sectors like information technology and startups, are making it difficult for borrowers to pay EMIs on time,” says Satish Mehta, founder, Athena CredXpert, which offers credit counselling.

Lenders, too, have erred by sanctioning loans without properly assessing repayment capacity. “Small personal loans, buy-now-pay-later (BNPL) loans, and checkout financing are often approved hastily, with minimal underwriting, leading to high debt burden,” says Ramamurthy.

If on the verge of default

If someone is nearing default, they must act quickly to avoid it, as recovery from default takes time. Start by reviewing your credit card statement to understand how much you owe. Don’t pay just the minimum balance to avoid late fees. “The interest rate on the outstanding balance could be as high as 40 per cent,” says Mehta.

Assess your income and expenses and slash non-essential expenditures. Next, consider refinancing your credit card debt. “Refinancing into a lower-cost, longer-tenure loan, such as a personal loan, or a loan against shares, mutual funds, or fixed deposits (FDs), may be beneficial. These loans typically have interest rates less than half of credit card debt,” says Ramamurthy.

Once you have defaulted

A loan default significantly lowers the credit score. “A default creates a vicious cycle—no new loans are granted due to a bad credit score, and without new loans, there’s no opportunity to improve the score,” says Ramamurthy. Even years after a default, loans may be offered at much higher interest rates.

One default can trigger others, so it is critical to avoid them. “Prioritise debt repayments, with home loans taking precedence, followed by other high-cost loans,” says Ramamurthy.

Mehta advises using savings or emergency funds to cover overdue payments. If no money is available, contact the lender and explain the reasons for default, especially if caused by job loss, health issues, and other genuine reasons. “Try to negotiate a debt restructuring plan. The lender may convert the outstanding debt into a term loan, repayable over 36-48 months, especially in the case of borrowers who show a genuine intent to repay,” says Ramamurthy.

Panwar recommends that defaulters should consider converting credit card debt into lower-interest debt (even after a default).

Avoid settling the loan

Under no circumstances should a borrower agree to a one-time settlement, wherein the lender writes off part of the debt. “While this clears the debt, the ‘settled’ status remains on their credit report, negatively affecting their credit score for a long time,” says Ramamurthy.

Finally, maintain a contingency fund equivalent to six months of expenses. This fund can help cover EMI payments during difficult times.

Tips for distressed borrowers

Do’s

-        Engage with the lender to explore options like loan restructuring, transfer to lower-cost loans

-        Prioritise paying off high-interest debts to prevent further strain

-        Seek professional advice from a credit repair company, if needed

Don’ts

-        Don’t adopt an ‘ostrich mentality’, like ignoring communication from the lender

-        Do not take new loans to pay off old defaults as it can lead to a debt trap

-        Refrain from using credit for discretionary expenses during financial stress