Does Pre-Closure Affect Credit Score?
Personal loans are one of the most useful tools for overcoming monetary hurdles. These loans are common because they do not require collateral from their applicants.
Borrowers often choose to pre-close their loans to relieve themselves of responsibility. Additionally, many people do this when thinking about getting another loan. But they don’t want to pay the payments on two loans.
If you’ve ever been through a pre-closure, you know how devastating it can be to your credit score. Also, getting approved for new credit or loans will be difficult for years to come.
We have discussed the effects of a pre-closure on your credit score below.
What is a pre-closure?
When you pay off a loan before the end of the term, the process is called pre-closing. Borrowers often resort to pre-closure to finally be free of their EMIs. You can reduce the interest the borrower owes if the loan is pre-closed.
Lenders let borrowers pre-close loans anywhere from 6–12 months after approval. It’s important to remember that there could be a pre-closure fine. And you will have to pay it if you want to pay off the loan before the conclusion of the agreed-upon term.
Impact of pre-closure on credit score
Paying on time each month is beneficial for your credit score. Hence, paying off your loan early should have the same effect. But no, this is not how things function.
There is a significant difference between paying off a loan and paying off credit card debt, or EMIs. Lenders consider the loan paid in full. They also consider the loan removed from your reports after you’ve made all the payments. Yet, credit rating agencies use your total balance across all accounts. They use these criteria when determining your credit score.
Credit ratings are affected more by how well you manage open accounts. They are less affected by the early closure of inactive accounts. Having open accounts can reveal your current and prior financial struggles.
Personal loans don’t have a huge effect on your credit score. Yet, making payments on closed loans on time and consistently is a big factor in your credit history. Remember that the same reasoning does not apply to paying a credit card balance.
An open credit card account is one that you’re still actively using. Thus, your credit score will not be affected if the balance is paid in full and remains untouched.
When Is the Right Time to Pre-close?
There are times when it makes more sense to prepay a personal loan. We’ll examine the following cases:
Initial stages of the loan’s term
You can significantly reduce the interest you would have paid on a loan. You have to pay it off early. Remember that most loan providers won’t let you prepay your loan within the first 6 to 12 months. In addition, there could be a fine for defaulting on a mortgage, even if you are authorised.
Think carefully about the costs and benefits of pre-closure before taking any action.
If your credit report and score are strong
If you have good credit, pre-closing on a personal loan will not affect your credit score. Further, it will convey a message to potential future lenders. Finally, it will show that you have the financial discipline to make timely payments on your debts.
When Should You Not Pre-Close Your Personal Loan?
When establishing a credit history and rating
If this is your first loan, paying it back on time will help you establish a good payment history. Timely repayment is a crucial factor in determining your credit score.
When the cost of the prepayment penalty exceeds the amount you will save
You won’t save a tonne of money by foreclosing on a loan. And that’s especially true if you’re already toward the end of the repayment period. You must also cover the prepayment penalty costs. Before deciding whether to prepay your debt, it’s important to weigh the pros and cons.
Advantages of Pre-Closing a Personal Loan
If you are able to pay off your personal loan early, you can get the following benefits:
Quick Process
A prepayment cancels your loan immediately. It is better than gradually decreasing it through regular EMI payments over time. There is no longer any need to make interest-only payments each month. Because of this, you can pay off the loan more quickly.
Low-Interest Outflow
You can reduce interest costs while prepaying a personal loan. It works both ways, in part or in full. It is usually better to absorb the prepayment fees than to pay the total interest on a personal loan.
No Prepayment Fees
Fees vary from one lender to the next. Yet, personal loans with a fluctuating interest rate are safe. They don’t incur any extra pre-closure fees, as per RBI regulations. You can save on interest and avoid prepayment penalties by paying off your loan early. But, pre-closure fees are your responsibility if you’ve chosen fixed interest rates.
Increased Creditworthiness
How quickly you pay off your bills directly impacts your credit rating. Suppose, you are currently making EMI payments on a loan and feel the need for a loan soon. In this case, your credit score may suffer as a result. In contrast, paying off a personal loan early can positively affect your credit score. It will make you more likely to get approved for future loans.
Things to Consider Before Your Prepay
Debt-to-income ratio
If you have a high debt-to-income (DTI) ratio, paying off your personal loans early may help. This is good news if you want another loan soon after paying off your current one. Your loan approval odds improve as your DTI goes down. A prepayment is an option if you first borrowed the money for an unexpected expense. But, you are now in a position to repay the loan.
Savings
Paying off your loan early can help you avoid interest penalties. But, using all your funds can be dangerous. You will negatively impact your ability to deal with sudden financial setbacks. Yet, you should only consider prepayment if you have a significant amount left. You must have enough money left after you’ve covered all other expenses. But, prepaying a personal loan when financial resources are low is not recommended.
Conclusion
If you have an outstanding personal loan, think carefully before foreclosing on it.
The decision to foreclose on a loan depends on the borrower’s financial situation. Hence, weigh the benefits and drawbacks, and make an informed decision.
If you want to improve your credit score, pre-close your loan. As a result, your credit rating and history will improve. Keep in mind that prepayment is typically penalised heavily for unsecured loans.
Instead of pre-closing a loan, you can make other investments with the available funds.
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