Personal loan pre-closure: 4 key factors to consider before paying off early | Mint

Have you recently received a lumpsum payment in the form of an annual bonus from the employer, variable pay, maturity amount from an investment, etc? Are you thinking of using it to close your personal loan? In this article, we will discuss what personal loan pre-closure is, its types, its benefits, and what factors you should consider before proceeding with it.

What is a personal loan pre-closure?

When you take a personal loan, the bank gives you a schedule with the EMI details. The schedule has the date till which the personal loan repayments will continue. When an individual decides to make a lumpsum payment and close the personal loan before its schedule, it is known as pre-closure. The lumpsum amount includes the outstanding principal and the pre-closure fees, if any.

There are two types of personal loan pre-closures. When an individual decides to pre-pay a partial amount against the outstanding principal, it is known as partial pre-closure. When you pre-pay partially, the bank will either reduce your EMI or the loan tenure. If you have a choice between the two, consider the following. Are you planning to invest the money saved into a SIP for a financial goal like a child’s higher education or your retirement? If yes, you must opt for a reduction in EMI. The amount saved from the EMI reduction can be channelled towards investments.

On the other hand, if all your investments are going on smoothly, you may opt to keep the EMI the same and ask the bank to reduce the loan tenure. Reducing the loan tenure and keeping the EMI the same will help you repay the personal loan faster.

When an individual decides to pre-pay the entire outstanding principal, it is known as full pre-closure. It is also known as foreclosure. If you foreclose the loan, make sure you collect the no dues certificate from the financial institution.

Benefits of pre-closure

The biggest benefit of a personal loan pre-closure is the interest amount savings. When you pre-close a personal loan fully, you don’t need to pay any EMIs in future. Each EMI has an interest component. Your total interest saving will be the sum of the interest component in the remaining EMIs due at the time of pre-closure. If there are any foreclosure charges, they will have to be deducted from the interest savings to arrive at the net amount saved by pre-closure.

When you pre-close a personal loan, it reduces your credit utilisation ratio and debt-to-income (DTI) ratio. The credit utilisation ratio measures the credit utilised from the overall credit limit available. The lower the credit utilisation ratio, the better for getting new loans/credit cards in future. So, when you pre-close a personal loan, it frees up your credit limit. With a higher available credit limit, you can get bigger amounts of loans in future, whenever you apply for them.

When you pre-close a personal loan, your debt-to-income (DTI) ratio goes down. The DTI ratio measures the percentage of income being used to service debt (loan EMIs and credit card outstanding). So, pre-closing a personal loan leads to a lower amount going towards servicing debt. The lower the DTI ratio, the better for getting new loans in future.

Some people feel uncomfortable with the thought of owing money to someone (individuals or financial institutions). It makes them stressed mentally. If you have only one personal loan running, pre-closing it will make you debt-free. The relief or joy of being debt-free is different altogether.

Factors to consider while deciding on pre-closure

Some of the factors that you must consider while deciding personal loan pre-closure include the following.

Lock-in period

Some financial institutions have a lock-in for personal loans. During the lock-in period, no partial or full pre-closure can be made. The lock-in period is usually six to twelve months. So, if you are planning to pre-close your personal loan, check if there is a lock-in period and its duration. If there is a lock-in period, check whether your personal loan has completed that period.

Foreclosure fee

Check whether your personal loan has a foreclosure fee and how much it is. Usually, the foreclosure fee is a percentage of the outstanding principal amount. Calculate how much will be the foreclosure fee amount. Compare the amount with the interest savings. If the foreclosure fee amount is higher than the interest savings, foreclosing the loan will not make sense. After considering the foreclosure fee, if the interest savings are meaningful, you may go for the foreclosure.

Building a credit score and history

If you are new to credit, any loans and/or credit cards are a good means for building and maintaining a good credit score. If you are looking to build a good credit score, and the ongoing personal loan is your only loan, you need to reconsider the decision to foreclose it. Once you foreclose the loan, the progress in your credit score will come to halt, provided you don’t have any other credit products.

Diverting funds from financial goals

The next point to consider is the purpose of the funds being used for the personal loan foreclosure. If the funds being used for foreclosure are being diverted from your financial goals, you must reconsider your foreclosure decision. Your financial goals should not suffer as a result of personal loan foreclosure.

Steps for personal loan pre-closure

After considering the above factors, now that you have decided to foreclose the personal loan, you should take the following steps.

1. Approach the bank/NBFC with a foreclosure request.
2. Check the outstanding principal, foreclosure fee, the documents to be submitted, etc.
3. Make the foreclosure payment and take the acknowledgement from the financial institution.
4. Once the foreclosure is completed, collect the No Dues Certificate and other documents, if any, from the financial institution.

Should you foreclose the personal loan?

A debt-free status has many financial and emotional benefits. In that context, one should aim to close loans in a reasonable period. However, it is not a straightforward decision. You have to consider factors like whether the loan has completed the lock-in period, are the interest savings meaningfully higher than the foreclosure fee, will the foreclosure halt your credit score progress or financial goals, etc. If the answers to these questions are favourable, you may go ahead with the personal loan foreclosure.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.