Is It A Good Idea To Pre-Close A Personal Loan?

A personal loan is often very useful for meeting unbudgeted expenses. Many banks, credit card companies and non-banking finance companies (NBFCs) offer pre-approved personal loans to their existing customers based on their credit behaviour. Of course, prospective borrowers can also reach out to other lenders with which they don’t have a banking relationship for a personal loan.

But all loans come with the responsibility to repay the money. The repayment is not just for the principal sum borrowed at the beginning but also the interest due and other charges associated with the loan.

A personal loan is a form of unsecured or collateral-free loan and so lenders attach a higher interest rate to such debt. Given that the interest payments due over the entire tenure of the loan itself can be a sizeable amount, if one has recourse to a windfall income, say a bonus payment by the employer or some other source of money, one should look at paying back part or all of the loan amount.

Full Prepayment

If one lands a chunk of money that is much more than the loan amount outstanding on that date, one can opt to pre-pay the entire sum.

Partial Prepayment

If one gets a lump sum money from some source but it is not enough to cover for the entire loan availed in the first place, one can still reduce the debt. This can be done by prepaying part of the outstanding loan amount.

Notably, even if one has extra sum that can help in fully retiring the entire loan, one may still choose to pre-pay only a part of the loan. This can be true if one is confident of using the extra money to invest that would gain more in value than the amount one would pay in terms of extra interest on the remaining loan amount.

Benefits Of Pre-Closure Of Personal Loan

• Reduce Monthly EMI:

If one is pre-paying part of the outstanding loan amount one can get the total equated monthly installment (EMI) reduced and thereby make it easier to service the remaining loan.

• Reduce Interest Outgo:

The biggest factor in favour of pre-closure of a personal loan is that it reduces the interest charges that the borrower pays in the future to service the loan. This can be a substantial sum and can be the main driver for such a decision.

• Improve Credit Score:

A spinoff effect of a pre-closure is that it reduces the unsecured loans availed by a person, which in turn improves the credit score. This is via two aspects: it shows that the person repays the loan on time, or in this case before time, and secondly, it reduces the total debt on his or her head. In both the cases it provides a positive picture in terms of creditworthiness of the borrower in the eyes of the lender.

Disadvantage Of Pre-Closure Of Personal Loan

• Penalty:

Lenders earn via the interest charges they levy while advancing a loan and when a borrower pre-pays the money the lender gets lower interest amount in the future. To cover for the loss of original anticipated interest income, lenders levy a penalty for pre-payments. This is a percentage of the outstanding loan amount.

• Opportunity Cost:

When one pre-pays a personal loan it is from a surplus cash they have access to. This extra money can also be used for other purposes such as investment. If one can invest the same money and gain a much higher return than what one is paying as an interest, one loses the opportunity to get that extra sum.

So, it is a good idea to pre-close a personal loan?

There are various factors that one needs to consider before making this choice. Different persons and their individual circumstances determine what they should do to make an efficient choice for themselves.

• If the penalties on pre-closure are very high and exceed the gains that would accrue if one opts for it and avoid future interest payments, then one should choose against such pre-payments.
• Pre-closure is more helpful in the early period of the loan tenure. So, if one has a two-year loan repayment period and one gets a lump sum income after six months then it may be more gainful than trying to repay the outstanding loan after 18 months. This is because the interest dues are much more in the initial stage of the tenure.
• If one is looking to avail another larger loan in the future and the current outstanding loan is pulling down the credit score, then it may be more helpful in pre-paying a personal loan if one has access to the money, as it will not just elevate the eligibility for a new loan but also push up the credit score to allow for sweeter terms of loan in the future.
• If one has availed a personal loan at a low interest rate due to high creditworthiness and he or she gets a lump sum amount that they are confident of investing and getting a higher return, it may be prudent to continue with the existing loan while investing that money. One would gain from that strategy.

Conclusion

The answer to the question whether one should pre-close a personal loan would depend on various factors and one would need to do a cost-benefit analysis on the pros and cons. This is both for partial or full pre-payment of such loans.

To begin with, however, prospective borrowers should choose lenders that not only approve personal loans without hassles but also provide several repayment options and minimal prepayment fees. IIFL Finance is one such lender. It offers personal loan of up to Rs 5 lakh for a maximum of 42 months with competitive interest rates via a swift digital process. The company also offers customized repayment options and allows borrowers to prepay their loans partly or fully by paying a nominal fee.