How Pre-Closure Of Personal Loan Can Impact Your Credit Score

Personal loans are one of the easiest solutions to take care of financial emergencies. They are easy to avail, do not require collateral and can be used for anything from funding a medical emergency to a home renovation to a holiday.

But once the emergency is over, most of us often worry about the burden of debt on our backs. It is natural to think of prepaying personal loans at the earliest, especially since they come at higher interest rates than other loans.

But is it good idea for borrowers to opt for pre-closure, or fully repaying before the due date, for a personal loan?

Pros and Cons Of Personal Loan Pre-Closure

Whether it is better for a borrower to prepay personal loans will depend on a number of things including the interest rate on the loan, remaining tenure of the loan and the pre-payment penalty. Personal loans usually have a lock-in period after which most lenders will allow prepayment after paying a penalty.

Prepayment of loans will reduce the debt burden of the borrower. If one has idle cash, it is better to prepay a personal loan in the early part of the loan to save on interest. It may not make much sense to prepay towards the end of the tenure, especially if prepayment charges are high.

One should evaluate the pros and cons to assess whether prepaying the loan with a penalty is better than holding idle cash. As a thumb rule, if the cash in hand earns less than what the borrower pays as interest plus penalty, it makes sense to prepay the loan.

Prepayment also increases the eligibility of borrowers to avail more loans. It reduces the debt-to-income ratio, a key metric most lenders look before sanctioning a loan. When prevailing market interest rates are low, it is advantageous to prepay the loan. One can prepay the loan and take another loan at lower interest.

Impact Of Early Closure Of Personal Loans On The Credit Score

The credit score is the first check for all lenders in a loan application process. Higher the score, the better are your chances of the loan being approved. So how does closure of a personal loan affect a borrower’s credit score?

Pre-closure will not have any significant impact on a borrower’s credit score, which ranges from 300 to 900. However, since credit scores are based on algorithm that takes into account a number of factors, including credit mix, payment history and credit utilisation, it can have a marginal positive or negative impact on the score temporarily.

A well-maintained credit mix using different types of secured loans like home and automobile loans and unsecured loans like credit card and personal loans can improve the credit score. Since too much dependence on unsecured loans is viewed negatively by the credit score metric, closure of personal loan can have a slightly positive effect.

The repayment history is one of the most important things a credit score algorithm will look at. It looks at history of timely repayment over a period of time. If you have been paying your loan on time, it improves your credit history. On the flip side, repaying loans early can mean lesser time for building that track record.

The algorithm also looks at credit utilisation. It is the amount of credit one uses as a proportion to the credit available. For example, in a credit card it will look at the outstanding credit as opposed to the credit limit. The higher the outstanding credit, the lower the credit score will be. So, closing a personal loan, while running a large outstanding on a credit card does not make much sense.

Credit bureaus look at open accounts to arrive at credit scores. When one clears a loan, the account will be closed. The credit score algorithm also looks at the number of new accounts opened and the number of accounts closed. It is better to apply for new credit in moderation, lest the algorithm will think that you are continuously looking for excessive credit.

Overall, the impact of prepaying a personal loan will have only temporary and small impact on the credit score. Effectively managing loan accounts that are open will have more impact on credit scores than prepaying an existing account.

Conclusion

When one decides to prepay a personal loan, it should be purely based on an assessment of the gains from the action.

Lenders like IIFL Finance offer personal loans via a simple online process that can be completed quickly and without much hassle. IIFL Finance provides personal loans for tenors ranging from three months to 42 months. It also allows you to easily prepay your personal loan by charging a nominal fee.