Loan Foreclosure: A loan foreclosure decision can have both positive and negative impact on your credit score.
In recent years, loan foreclosure has become a common practice among borrowers due to the desire to repay the loan and save interest. However, the decision to foreclose a loan can have both positive and negative effects on your credit score, depending on the situation. It is important for borrowers to understand these effects to make the right decisions about their financial situation.
What is loan foreclosure?
Loan foreclosure, also known as pre-closure, involves paying off the entire outstanding loan amount in a lump sum before the loan tenure ends. This option is available for most loans in India, allowing borrowers to close their loan early, often to avoid further interest payments or to better manage their debt.
Positive impact on credit score
Loan foreclosure can have several positive effects on your credit score:
Better credit: If you foreclose a loan without missing any EMIs or defaulting, it reflects positively on your credit history. Credit bureaus like CIBIL consider this a sign of good financial management, which can increase your credit score and improve your chances of getting a loan in the future.
“If you have held the loan for a long enough period and have made regular on-time payments, foreclosing it can increase your score or at least keep it stable. But if you close it too early, for example, immediately after taking the loan, it can impact your score slightly, as you are not giving the credit bureaus enough time to assess your payment history,” said Kunal Verma, co-founder and CEO, Frio.
Financial flexibility: Loan foreclosure can help you save money on interest payments, especially on long-term loans. This can improve your cash position and reduce financial stress, allowing you to better manage your other financial priorities.
Negative impact on credit score
Despite the benefits, there are some potential disadvantages to keep in mind
Temporary credit score reduction: A loan foreclosure can temporarily lower your credit score, especially if it involves outstanding EMIs. This is because lending institutions rely on credit bureaus such as CIBIL to assess your creditworthiness, and a low score can temporarily impact your borrowing ability.
Prepayment penalty: Many lending institutions charge a penalty for early loan foreclosure, which can negate the savings from interest payments. These charges can vary between lending institutions and can range from 1 per cent to 5 per cent or more of the outstanding amount.
Short credit history: Closing a loan early reduces the length of your credit history with that loan. Financial institutions value long and regular payment history, and a short credit history can have a negative impact on your credit profile.
Adhil Shetty, CEO, Bankbazaar.com said, “Foreclosing a long-term loan, such as a home loan, too early may slightly lower your credit score in the short-term as it reduces your credit mix and longer payment history. Both of these positively impact your credit score. It is important to understand that the lending institution reports the loan to the credit bureaus as ‘closed’ and not ‘settled’ as the latter can have a negative impact on your score. Loan foreclosure can be a financially smart move if done correctly. Always compare the interest savings and the reduction in the length of credit history.”
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