Do you have an ongoing personal loan? Do you want to finish it as soon as possible so that you’ve got one less debt to worry about?
We’re sure the answer is YES! All borrowers want to close their existing debts and enjoy a debt-free life. However, pre-closing a personal loan (paying the outstanding amount in bulk, before the end of the tenure) may not always be a good idea. It can negatively impact your credit score, and hamper your chances of building a good credit history.
Here, in this guide, we show you why foreclosing a personal loan may not always be the smart move, especially if you're looking to build your credit history.
Types of Personal Loan Closures
A personal loan is one of the most sought after types of loans. There are several benefits of taking a personal loan.
No restriction on how you spend the loan amount
Readily available, instant sanction and disbursal of funds
No need for collateral, minimal documentation
With commercial banks, NBFCs, and digital lenders offering personal loans, customers are spoilt for choice. Furthermore, the increased competition ensures that you can avail personal loans at a suitable interest rate that works for you.
Just like all other loans, when you take a personal loan, the borrowed amount is credited into your bank account. You then repay the loan (principal + interest) in the form of monthly EMIs.
When it comes to personal loan closures, there are two major types of closures:
This is when a borrower repays the loan, as per schedule. Let's say you take a personal loan for a tenure of three years. Then you repay the borrowed amount and the interest as fixed monthly EMIs for the whole three-year period. At the end of the last EMI payment, your outstanding balance is zero, and your loan is closed by the lender. There are no closure charges when you stick to the original schedule.
Foreclosure or Pre-closure
As the term implies, this is when you repay the loan amount before the end of the tenure. One primary reason why borrowers go for foreclosure is to be relieved of the debt burden. Additionally, by pre-closing the loan, you can save some money on the interest owed to the borrower.
Generally, most lenders allow borrowers to pre-close their personal loans after six to twelve months from the date of loan sanction. Note that you may have to pay a pre-closure penalty if you wish to repay the loan before the end of the agreed tenure.
Breaking the Myth: An Ongoing Loan lowers your Credit Score.
One of the biggest myths regarding loans is that – an ongoing loan lowers your credit score. Very often, borrowers assume that their low credit score is because they have got a loan going on. As a result, they take the worst step – pre-close the existing mortgage to increase their credit score.
Let's see why this is a wrong move.
Paying EMI regularly demonstrates your Repayment Credibility and improves your Credit Score and Credit History.
Let's say you have a poor credit score or zero credit history. How do you show prospective lenders that you can afford a loan, and you will repay it regularly? You can demonstrate your repayment capability to the lender, only when you have repaid a loan in full, and according to schedule.
Let's say you have an ongoing personal loan. When you pay the monthly EMIs on time, the information is sent to the credit bureau. The credit bureau notes it in your credit history, and when you finish the loan on time, you're awarded an increase in your credit score.
As you can see, repaying an ongoing loan on time boosts your credit score in a positive way and also improves your credit report. This improves your eligibility for future loans.
When does it make sense to pre-close an ongoing personal loan?
There are specific scenarios when pre-closing a personal loan may be the better choice for you. Let's take a look at these situations:
Early in the loan tenure
When you foreclose your loan with full payment relatively early in the tenure, you can save a significant amount of the interest. However, note that most lenders do not allow borrowers to pre-close a loan in the first six to twelve months of the tenure. And, even if you're approved, there may be a foreclosure penalty.
So, make sure to do a cost-benefit analysis to determine whether foreclosing the loan works to your benefit.
When you have a good credit history and score
If you already have a good credit score, foreclosing a personal loan may not significantly impact your credit score. Additionally, it will signal to future lenders that you are committed to repaying your debts on time.
When should you NOT foreclose a personal loan?
When you’re building your credit history and score
If this is your first time borrowing, then repaying the loan as per schedule will help you build your credit history and score.
When the prepayment penalty charges are higher than the savings you get
Foreclosing a loan, especially in the latter stages of the tenure, will not help you enjoy huge savings. Additionally, you will also have to pay the prepayment penalty fees. Make sure to work out the costs and benefits to decide if prepaying the loan works to your advantage.
Analyse your Situation Carefully, before Foreclosing your Ongoing Personal Loan
As you can see, foreclosing a loan may or may not be the right choice, depending on your financial situation. So, make sure to work out the pros and cons of the move and decide whether it's the right choice for you.
If you're trying to build your credit history and score, then keeping the loan active, shows that you are capable of successfully managing credits. This, in turn, boosts your credit score and improves your credit history. Also, note that most personal loans come with a hefty prepayment penalty.
If you have some extra money in hand, you can invest it elsewhere, instead of rushing to pre-close an ongoing loan.