Is foreclosing a loan good or bad for your credit score? Explained

Paying a loan before the full tenure is generally seen as a good sign by lenders

Don't want to miss the best from Business Standard?

In recent years, loan foreclosure has become a common practice among borrowers, driven by the desire to reduce debt burdens and save on interest payments. However, the decision to foreclose a loan can have both positive and negative impacts on one's credit score, depending on the circumstances. Understanding these effects is crucial for borrowers to make informed decisions about their financial health.

 

What is loan foreclosure?

 

Loan foreclosure, also known as pre-closure, involves paying off the entire outstanding loan amount in a single lump sum before the end of the loan tenure. This option is available for most loans in India, allowing borrowers to close their loans early, often to avoid further interest payments or to manage their debt more effectively.

 

Positive impact on credit score

 

Foreclosing a loan can have several positive effects on your credit score:

 

Improved creditworthiness: If you foreclose a loan without any missed EMIs or defaults, it reflects positively in your credit history. Credit bureaus like Cibil view this as a sign of good financial management, potentially boosting your credit score and making you more eligible for future loans.

  “If you have had the loan for a reasonable period and made consistent on-time payments, foreclosing it can boost your score or at least keep it stable. But if you shut it too early—say, right after taking it—it might slightly affect your score because you’re not giving the credit bureau enough repayment history to assess,” said Kunal Varma, co-founder and CEO, Freo.

 

Financial flexibility: Foreclosing a loan can save you money on interest payments, especially for long-term loans. This can lead to improved cash flow and reduced financial stress, allowing you to manage other financial priorities more effectively.

 

Negative impact on credit score

  Despite the benefits, there are also potential downsides to consider:

  Temporary credit score drop: Foreclosing a loan can cause a temporary dip in your credit score, especially if it involves overdue EMIs. This is because lenders rely on credit bureaus like Cibil to assess your creditworthiness, and a lower score can temporarily affect your borrowing power.  Calculate EMI: EMI Calculator Tool

 

Prepayment penalties: Many lenders charge penalties for early loan foreclosure, which can offset the savings from interest payments. These charges vary between lenders and can range from 1 per cent to 5 per cent  or more of the outstanding balance.

  Shorter credit history: Closing a loan early reduces the length of your credit history with that particular loan. Financial institutions value long, consistent repayment histories, and a shorter credit history might impact your credit profile negatively.

 

“Foreclosing a long-term loan too early, such as a home loan, may slightly lower your credit score in the short term, as it reduces your credit mix and long repayment history - both of which positively influence your credit score. It is important to understand that the lender reports the closure as ‘closed’ and not ‘settled’ to credit bureaus, as the latter can negatively impact your score. Foreclosing a loan is financially smart when done right. Always weigh the interest savings against the potential dip in credit history length,” said Adhil Shetty, CEO of Bankbazaar.com.