The need for credit can come up anytime for any individual. Though individuals save and invest, certain immediate situations like a medical emergency or death in the family make not leave you enough time to plan your finances. Personal loans play a major role here, as the loan can be availed for any reason. Moreover, there is no collateral requirement, which makes it even more attractive.
Banks and other Non-Banking Financial Companies are hugely helpful when it comes to taking a loan for your immediate needs. However, the loan does not come cheap and you may end up paying more than you have borrowed with interest. Personal loans being collateral free are generally charged higher interest rate than secured loans like a home loan or vehicle loan.
While these loans may satisfy your need for credit, the interest charged being on the higher side may make a dent in your everyday finance.
And who doesn't want to live a debt-free life? And wouldn’t you want to do that when you get a chance to pay off your entire loan as a single payment?
Additional Reading: The right way to close your personal loan
But will prepayment of a personal loan have an impact on your credit score? If so, is it positive or negative?
Some people have the misconceptions that pre-closing a personal loan will have a negative influence on the credit score. On contrary to their belief, pre-closing a personal loan can help an individual in terms of availing future credit and improving the credit score.
Let's see how.
Personal Loan Pre-closure and Credit Score
You may have a sudden gain of wealth in the form of bonus, increment or profit from the business, or might even have saved up to close your personal loan. You may want to use it to close a good part of your high-interest debt like a personal loan. This is a good step and you can benefit a lot from it. Personal loans are unsecured loans and prepayment will have a positive impact on your credit score.
A Credit score is derived from many underlying factors which are attached different weights.
The factors that get affected when you prepay a personal loan are
Your Credit Accounts
Credit Mix shows the proportion of secured and unsecured accounts in your credit portfolio. Secured loans are home loans, vehicle loans or gold loans, while credit cards and personal loans are unsecured borrowings. Credit bureaus and lenders look for a credit portfolio that has a good mix of both the kind of accounts.
So, when you look to pre-close your personal loan, you are in fact reducing the amount of unsecured credit in your credit portfolio which is a huge positive for your credit score.
While defaults and late payments of personal loans will adversely impact your credit score, pre-closure influences your future credit positively. It shows to the lenders that you have an ability to repay the loan at the earliest. It is the proof of accountability and reliability. Hence, the credit score improves on the pre-closure and gets updated in your credit report.
You can also opt for partial repayment on your personal loan, on which the tenor remains the same, but a good amount of interest can be saved by paying out the principal outstanding. This, however, does not have any immediate effect on your credit score.
Your Credit Accounts
To have a good credit score, it is necessary that your credit accounts are positive at all times, which in turn conveys that you have been prompt in repayment of your credit accounts. This not only sends out a strong sign of creditworthiness to your future lenders but also improves your credit score.
When you pre-pay a personal loan account, that account will be shown as positive as you have closed it to the satisfaction of your lender and that too before the tenure of the loan.
Prepaying a personal loan will help you improve your credit score.
The Impact of Personal Loan Prepayment on Your Future Credit
Pre-closure of your personal loan can remain in your credit report for a long time. The lenders make a credit inquiry when you apply a loan or credit card in the future. Prepayment is viewed as a good credit behavior by the banks as it shows your ability to repay at the earliest. Hence, the chance of getting a loan or credit card at better terms is very much possible due to your prepayment.
Also, as you are reducing one loan from your portfolio, you free up that much income of yours. Hence, when you apply for any further credit, you repayment capacity is enhanced by pre-closing the personal loan. If you are looking to apply for a big-ticket long term commitment like a home loan, it is good to clear off your personal loan, especially if you are on the lower end of the income or have another long term loan like an education loan or vehicle loan.
Though pre-closure of a personal loan will have a positive impact on your credit score, it is economically beneficial only if it is done earlier during the tenure of the loan. Most personal loans come at a pre-payment penalty of a certain percentage of the outstanding amount.
It is always good to do a cost-benefit analysis before paying off the loan. Hence, make the right decision at the right moment and enjoy being credit healthy.