All About Pre-clousre


What is pre-closure?

Pre-closure is the facility offered by financial institutions to their customers that allows them to repay the entire outstanding amount before the binding due date in one go. Pre-closure of a loan account is allowed after the completion of the lock-in period, which can range from one to three years. The lender may impose a pre-closure penalty depending on the loan type, the duration the customer chooses the pre-closure facility, and the loan terms.

KEY TAKEAWAYS

  • Pre-closure refers to the payment of the entire outstanding loan amount ahead of the loan agreement’s actual repayment term.
  • Depending on the loan type, it has a one to three-year lock-in period.
  • In some cases, pre-closure incurs a penalty calculated on the outstanding amount.

Advantages of pre-closure

Choosing a pre-closure is always advantageous, whether you are a salaried or self-employed individual. Here is how:

Lowers debt burden

If you are stuck with multiple debts, pre-closure is the best option. By foreclosing on one or two of your debts, you can significantly reduce your EMI burden and manage your finances more effectively. Further, it helps to reduce your debt-to-income ratio, allowing you to apply for another loan with better terms in the future.

Lesser interest outgo

You may be aware that extending the repayment period results in a higher interest outlay. Assume you and your friend each took out a Personal Loan of ₹5,00,000, with the lender charging a 13% interest rate on both of you. However, you chose a five-year repayment period for this loan while your friend opts for a two-year repayment period.

The table below shows how the interest outgo for each loan varies.

Parameters 5 years repayment period 2 years repayment period
Loan amount ₹5,00,000 ₹5,00,000
Interest Rate 13% 13%
EMI ₹11,377 ₹23,771
Interest payable ₹1,82,592 ₹70,502
Total payable ₹6,82,592 ₹5,70,502

 

You can see the difference in total interest payable for both tenures. Thus, choose pre-closure or a shorter loan term if you want to save money on interest payments.

More disposable income

Since pre-closure saves you money on interest payments, you can invest your savings in any investment scheme. The returns on such investments can help supplement your current income.

Safeguard your asset

If you are unsure about your future solvency, pre-closure makes sense. If you have a secured loan backed by a valuable asset, closing your loan ahead of time keeps you out of default and safeguards your asset from being auctioned.

Disadvantages of pre-closure

Even though pre-closure is advantageous in many ways, it also has a few drawbacks, which are listed below.

Pre-closure penalty

As previously stated, pre-closure carries a cost. The penalty could be between 1% and 5% of the outstanding amount. As a result, closing your debt well in advance may disrupt your budget if you pay the penalty upfront.

Alternative option

Paying a major part of your debts in one lump sum may not always be a wise decision, especially if you have a secured loan with a lower interest rate. The reason for this is that the money you paid for pre-closure can be invested in a scheme that pays a higher interest rate than what is charged by your lender.

Lock-in period

Even if you have sufficient funds, you cannot choose pre-closure until you have successfully completed the lock-in period. In the case of a Personal Loan, most financial institutions have a one-year lock-in period.

Why do some lenders charge a pre-closure fee?

The lender loses a significant amount of interest income when you choose to pay off your loan before the actual repayment period specified in your policy document. Assume you have a ₹30,00,000 Mortgage Loan with a 15-year repayment term. According to your loan agreement, the interest rate is 9%. The total interest payable here is ₹24,77,040. Now, if you choose to pre-close your loan after successfully repaying the EMI for five years, the lender will suffer a loss of ₹17,40,536.

The pre-closure penalty helps lenders mitigate their losses. Here is a list of loan products and information about their pre-closure penalties to help you understand this point better.

Personal Loan:

Personal loans are short-term loans that help lenders generate quick cash flow. If you pre-close this loan, the lender will charge you a penalty of 3% to 5%.

Home Loan:

If you have a Home Loan with a fixed interest rate, the lender will impose a fee ranging from 1% to 5% for pre-closure.

Vehicle loan:

Vehicle loan refers to Pre-Owned Car loans, two-wheeler loans, and new car loans. When pre-closing such a loan, be ready to pay a penalty of 1% to 6%.

Education loan:

If you have taken a loan to pursue your undergraduate or postgraduate studies and want to close your loan early, the pre-closure fee will be between 1% and 4%.

Loan Against Property:

This loan is backed by land or building and can assist you in meeting your financial needs, whether personal or professional. If you have taken this loan and want to pre-close it, you will have to pay a penalty of 2% to 5%.

Impact of pre-closure on credit score?

Early loan repayment improves your credit score significantly. Soon after you are approved for funds and receive the money in your account, the information is sent to the credit bureau. They then decide your credit score based on your EMI payment pattern. When you pay off your loan on time or ahead of schedule, credit bureaus learn that you have strong repayment potential and are financially stable.

On the other hand, if you have a low income, it will be difficult for you to manage your EMIs. As a result, you would contact your lender to reschedule your loan. If the lender grants a repayment extension, your credit score will suffer because it indicates to credit agencies that you have poor repayment ability.

Pre-closure vs prepayment

Prepayment of a loan refers to a situation when you choose to pay a portion of your outstanding debt before the due date. Prepayment allows you to either increase your EMIs or pay off the majority of your debt in one lump sum. The lender may or may not impose a prepayment penalty depending on the type of prepayment you select.

On the other hand, pre-closure is a legal process in which you choose to pay off the entire outstanding debt in a single payment.

When is the ideal time to pre-close a loan?

Choosing a pre-closure will be considered a wise move if you find yourself in any of the following situations.

Floating interest rate loan:

The Reserve Bank of India (RBI) has issued a directive instructing lenders not to charge a pre-closure penalty on a floating rate home loan. Floating rate loans have interest rates that fluctuate due to external factors, such as the RBI’s base rate. If you have this type of home loan, pre-closing to save on interest payments is a wise move.

Poor credit score:

If this is your first loan, you will want to improve your credit score to be eligible for a larger loan in the future. Similarly, if you have a loan default or missed EMIs on your record, you will surely want to repair your credit score. Pre-closure can assist you in both of the preceding scenarios.

Surplus funds:

If you received a windfall gain from stock trading, a bonus from your employer, or your investment matures and provides a lump sum payment, use it to fund a pre-closure. However, carefully consider your investment options and long-term or short-term goals before proceeding further.

Final words

Pre-closure is an excellent option if you want to improve your credit score and qualify for a larger loan in the future. When a lender performs a soft credit check to select borrowers for a pre-approved loan and discovers pre-closure information on your report, you may be eligible for this loan product. However, before deciding on a pre-closure option, consider your budget and future goals.

Other Words

  • Prepayment
  • Processing Fee
  • Proprietorship
  • Partial Disbursement

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