Debt settlement offers immediate relief but damages your credit score

Indians are drowning in debt. India’s household debt levels are reported to have reached a record high of 40 per cent of Gross Domestic Product (GDP) in December 2023, according to a report from financial services firm Motilal Oswal. Furthermore, 

unsecured debt like personal loan has grown at a faster pace than secured debt. Here are a few common mistakes borrowers need to avoid while trying to come out of a debt trap.   

Debt settlement 

A debt settlement involves negotiating a single payment with the creditor that is lower than the amount owed. Lenders may agree to this — they recover something rather than nothing at all. A credit card bill of Rs 2 lakh may, for instance, get settled at Rs 1.25 lakh. It may look like you have got a good deal, but debt settlement has many negatives. 

 

Mistake: Borrowers overlook the long-term consequences of settling debt. “While paying off debt provides immediate relief, it can affect your credit score negatively, potentially hindering the sanction of future loans or increasing interest rates on them,” says Raoul Kapoor, co-chief executive officer (CEO), Andromeda Sales and Distribution. Not taking everything in writing is another error. “Secure a settlement agreement in writing before paying,” says Raj Khosla, founder and managing director, MyMoneymantra.com.   

Another mistake, he says, is not bargaining. Settling isn’t good, but if you must, get the best deal. 

Advice: Settle with the lender directly, not with a third-party debt settlement firm. At the very least, do the due diligence on the bank-appointed third-party firm.

Credit card balance transfer 

Transferring the balance from one credit card to another can help you manage your credit card debt more effectively and save on interest. You can reduce finance charges and late fees on multiple credit cards by transferring your debts to one card that has zero per cent interest for a limited time. 

Mistake: The mistake lies in trying to play the debt rotation game. 

“If you are doing it just to postpone payment, it may backfire. Balance transfer can be a useful tool only if you have the financial discipline to make regular payments and avoid adding new charges to the card,” says Adhil Shetty, CEO, Bankbazaar.com.   

Advice: Read the new card’s terms carefully. “Make sure you fully understand the terms of balance transfer, such as fees, introductory rates, and the duration of the low-interest offer. Plan to pay off the balance before the promotional period ends, and keep the old account in good standing to maintain a healthy credit history,” says Shetty.  

 

Debt consolidation 

It refers to taking a new debt to pay off multiple existing ones. That single, larger loan must offer more 

favourable terms. 

“The primary objective of availing loans for debt consolidation is to reduce one’s interest cost by replacing loans availed at higher interest rates with a loan having a lower interest rate,” says Sahil Arora, chief business officer (unsecured loans), Paisabazaar. This loan should be of a longer tenure than the existing credit facilities.
 

“Doing so will reduce the EMI and save the borrower from ballooning debt caused by the capitalisation of penal rates and charges,” says Arora.  Managing your debts will become easier as you will have to make only one monthly payment. 

Mistake: One mistake is locking into the first interest rate the debt consolidation lender or agency offers. “It only makes sense if the average interest rate on all the debts is reduced,” says Jigar Patel, member, the Association of Registered Investment Advisors (ARIA). 

Another mistake is going for the lowest possible EMI, instead of one that you find manageable. Selecting the lowest monthly payment will mean opting for the longest loan term available. This will raise your interest cost further. 

Advice: First try to avail of a loan against an asset like gold or property, or a top-up loan on an existing home loan.“Borrowers seeking consolidation should first check with lenders with whom they maintain deposits, loans or credit cards, whether they qualify for lower rates,” says Arora. If they don’t get a low-cost loan from them, they should try loan aggregator 

platforms.