Personal loans are undoubtedly one of the best instant sources of funding to tackle cash crunches. They can be used for any purpose like home renovation, wedding, medical emergencies, travel, etc. Since these loans do not require any collateral, they are quite popular.
There will be times when borrowers prefer to pre-pay the loan ahead of time to get rid of the existing debt. Many also do this if they are planning to take other loans and do not want to service multiple loans at a time. So, read on to find out if prepayment is a viable option for you and how it affects your credit score.
What is Personal Loan Prepayment?
Prepayment of a personal loan means repaying the entire outstanding amount or paying a part of it before the due date as agreed upon. The bank or lender will charge a fee on foreclosure of the loan. This depends on the amount of loan outstanding after prepayment and also according to the number of EMIs paid. Some banks may not charge anything if the personal loan is prepaid after 12 EMIs.
What Is The Impact of Personal Loan Prepayment on Credit Score?
Whenever you pay off your loan completely, it indicates a closed account on your credit report. However, computation of credit score involves open accounts. Paying off a loan differs entirely from clearing the dues of credit cards and paying EMIs. Clearing off dues like loans reflects a closed account in your credit report. However, when computing your credit score, credit rating bureaus consider your open accounts.
Managing the finances of the open accounts effectively has a greater impact on the credit scores. This is because open accounts show your present and past debt history. Although timely and regular payments on closed loan accounts form a crucial part of your credit history, the impact is not too significant. However, this does not apply to credit card accounts. An active credit card account is always considered as an open account. Thus, even when there is full balance and untouched, your credit line stays intact.
Credit scoring models are complicated and consider various factors. While loan prepayment can have some impact on your credit score, it is not the only influencing factor. Additionally, the impact of prepayment on credit score can vary based on individual circumstances and credit scoring models.
Things To Know Before You Prepay Your Personal Loan
- Lowers Debt to Income Ratio
Personal loan pre-payment can reduce your debt-to-income ratio (DTI) since the quantum of debt will reduce. This is beneficial for you if you are going to apply for another loan immediately. Because, the lower your debt to income ratio, the higher your chances of loan approval. So, it is ideal to prepay if you are going to apply for another loan immediately after prepaying.
If prepaying your personal loan depletes your savings, then it is not a good idea to do so. As then, you will be in a cash crunch when you meet with emergency expenditures. But, even after you prepay your personal loan, if you are left with enough savings to deal with unforeseen expenditures, then it is a good idea to prepay your personal loan.
- Prepayment Lock-In Period
Most banks will have a lock-in period during which you will not be allowed to prepay your loan. However, there is no lock-in period for floating rate loans.
- Prepayment Penalty
A penalty may be levied for loan prepayment before the end of the Lock-in-period for business loans and non floating rate loans. So, before you decide to prepay your loan, check the penalty. If the penalty exceeds the savings on interest, you may have to reconsider prepaying the loan.
- Interest Rate of Loan
The interest component of the loan is higher in the beginning and reduces as the tenure decreases. It is computed on the reducing balance method by most banks.
Benefits of Loan Prepayment
- You can save on interest costs: If you pay the loan amount only by the due date, then the total outgo of interest will be higher. On the other hand, on foreclosure of your personal loan, your interest outgo will reduce.
- Even Part Prepayment is Beneficial: Even part prepayment is helpful when you are short of funds. It helps you save on the interest outgo by reducing the outstanding amount. This helps you in saving up for the shortage of funds.
Cons of Loan Prepayment
- Prepayment Charges:
While some secured loans do not have prepayment charges, you have to pay prepayment charges on personal loan foreclosure. Customers are also advised not to go in for packages that provide low prepayment fees. You can compare interest rates against the prepayment charges. If the prepayment fee is high, and the interest rate is low, then it is ideal to choose that. Prepayment fees differ depending upon the completed loan tenure.
- Depletion of a large number of funds: Individuals would have saved cash to use it as a buffer for cash crunch situations or invest it wherever they wish to create a fund. If they foreclose the loan, then they will have to spend a large number of funds they have in hand on foreclosing.
Although loan prepayment affects credit score, the impact is not too significant. It is not the sole determinant of your credit score. But, when you prepay your loan, make sure you have enough funds for it.