Unquestionably, personal loans are among the best tools for overcoming financial difficulties and reaching significant life milestones. These loans are obviously highly popular because applicants are not required to put up any collateral.
All borrowers desire to pay off their current debts and live debt-free. Pre-closing a personal loan—paying down the entire balance before the term is up—might not always be a smart move. It may lower your credit score and make it more difficult for you to have a solid credit history.
In this post, we’ll explain why it’s not always a good idea to foreclose on a personal loan, particularly if you’re trying to establish your credit.
Types of personal loan closure
One of the most popular kinds of loans is a personal loan. The use of a personal loan has a number of advantages.
There are no limitations on how to use the loan proceeds.
Quick approval, disbursement, and availability of money
No need for collateral, little paperwork
Customers have a wide range of options thanks to the personal loans offered by commercial banks, NBFCs, and digital lenders. Additionally, the increasing competition makes it possible for you to get personal loans at an interest rate that is reasonable for you.
When you take out a personal loan, the borrowed amount is deposited into your bank account, just like with all other loans. Following that, you make monthly EMI payments to repay the loan (principal plus interest).
Closing a personal loan in India generally fall into one of two categories:
This occurs when the borrower makes the agreed-upon loan repayments. Consider taking out a personal loan with a three-year term. Then, for the full three years, you pay back the borrowed money plus interest in fixed monthly installments. Your loan is terminated by the lender when your outstanding balance is zero following the final EMI payment. When you follow the original schedule, there are no closure fees.
Foreclosure or pre-closure
As the name suggests, this occurs when you pay back the loan amount before the period has expired. To be free of the burden of debt, borrowers frequently file for foreclosure. Additionally, you can reduce the amount of interest owing to the borrower by pre-closing the transaction.
In general, after six to twelve months from the day the loan was sanctioned, most lenders permit borrowers to pre-close their personal loans. Remember that if you want to pay off the loan before the agreed-upon tenure is up, you might have to pay a pre-closure penalty.
Eliminating the Myth: Continuous debt can harm your credit score.
One of the biggest misunderstandings surrounding loans is the idea that having an open loan can harm your credit. Borrowers frequently believe that having a loan open is the cause of their poor credit score. As a result, they pre-close the existing mortgage in order to raise their credit score, which is the worst possible action.
Let’s look at why this is a bad choice.
Regular EMI payments enhance your credit history and score while demonstrating your repayment credibility.
Consider the case where you have no credit history or a low credit score. How can you demonstrate to potential lenders that you can afford a loan and that you will make regular payments on it? Only when you have fully and on time returned a loan can you show the lender that you are capable of making payments.
Say you are still paying off personal debt. The information is communicated to the credit bureau when you make on-time monthly EMI payments. When you repay the loan on time, the credit bureau records it in your credit history, and your credit score is raised.
As you can see, timely loan repayment raises your credit score and enhances both your credit report and credit score. This increases your qualification for upcoming loans.
When is it wise to pre-close a personal loan that is already in progress?
In some circumstances, pre-closing a personal loan might be the wiser move for you. Let’s examine the following instances:
Early in the loan tenure
You can save a lot of money by foreclosing on your loan with full payment relatively early in the term. The majority of lenders do not, however, let borrowers to pre-close a loan within the first six to twelve months of the term. Additionally, there can be a foreclosure penalty even if you are accepted.
Do a cost-benefit analysis to see whether foreclosing on the loan will be to your advantage.
When you have a good credit history and score
Foreclosing on a personal loan might not have a big influence on your credit score if you already have a high score. Additionally, it will convey to potential creditors your commitment to timely debt repayment.
When should you not foreclose a personal loan?
When you are building your credit history and score
If this is your first loan, paying it back on time will help you establish a credit history and score.
When the pre-payment charges are higher than the savings you get
Closing a loan won’t enable you to realize significant savings, especially later in the term. You will also be responsible for paying the prepayment penalties. Make sure to weigh the advantages and disadvantages of prepaying the loan before deciding whether to do so.