Though all kind of loans have become very common now yet most borrowers feel that it is kind of a burden that they should get off as soon possible. It may seem like a good idea to repay the loan earlier than the original term specified (if one has surplus funds) to reduce the interest cost and also the mental burden that one associates with a loan. Before foreclosing a loan the borrower needs to consider various aspects like the tax factor in case of home loans, prepayment charges if applicable, the savings in terms of the interest paid compared to the loss of an investment opportunity (the funds that are used for foreclosure can be invested elsewhere). Apart from this another factor that must be considered is the impact on the CIBIL Score if any.
Loan Foreclosure Explained:
Loans are taken at an agreed rate of interest for a specified time period which is known as the loan term. When the borrower pays the amount before the specified term it is known as foreclosure or part prepayment depending on how much is paid. When the repaid amount is part of outstanding amount then it is known as partial payment and if the entire outstanding amount is repaid then it is known as foreclosure of loan. Depending on the lender’s policies and the type of loan the rules for pre-payment and foreclosure may vary.
How Loan Foreclosure Impacts CIBIL Score?
The borrower may feel foreclosure is a good thing financially as well as for the credit rating but it is not so. From the lender’s perspective this may not be the case as the lender has planned for interest inflow for the entire loan tenure, prepaying a loan can upset the lender’s projections. Foreclosing a loan leads to idle cash being piled up at the bank which can cause them worry. Lenders generally try to dissuade borrowers from paying early on foreclosing a loan but for home loans the penalty charges have been waived off by most lenders for home loans at least.
Now let us assess the impact of foreclosure on the credit rating. When one repays a loan regularly it creates a healthy credit trail which helps in creating a good credit score. Repayment history is the biggest factor that contributes (35%) to the CIBIL Score. A deeper credit history gives a better picture about the loan bearing capacity and also the creditworthiness of an individual which helps the lenders in assessing the applicant. A well serviced loan that runs for the full duration will help in creating a healthy credit rating.
A healthy credit mix is very important for a good credit rating; this means that there should be good balance of secured loans like home and car and unsecured loans like a personal loan and credit card borrowings. So if the borrower repays a secured loan then it is likely to skew the ratio of secured and unsecured loans which is likely to adversely impact the credit rating. However repaying a personal loan is not likely to impact the credit rating so much and in certain cases may actually benefit the credit rating.
A person with higher ratio of secured loans presents a more reliable picture then someone with only unsecured loans. Secured loans are backed by collaterals and have lower EMIs when compared to unsecured loans, which means in case of default the risk is mitigated. Repaying a loan also compromises the liquidity of the individual temporarily. A loan that is managed well and runs the course of the entire loan tenure reflects a person who is good at managing his finances and planning ahead.
In certain situation foreclosing a loan may be beneficial. This could be if one has an expensive loan which he/she wants to repay or if one is already overleveraged then they might want to repay a loan and try and take some time to get their credit rating back in shape
The impact of foreclosure of a loan may vary from situation to situation. In some situations it can help the person better his score; like if they are prepaying unsecured loans to balance the ratio of secured and unsecured loans or if they are already overleveraged. In some situations foreclosing a loan may temporarily dip the score but it will be a short term impact only.
Before foreclosing a loan one should consider all aspects (as mentioned in the beginning) and not only the impact on the credit rating before making this decision.