Should you be foreclosing your running loan accounts? Impact on credit score explained

Foreclosure of loan accounts refers to the early closure of the loan account with the institution, ahead of the tenure. The purpose of the same is to avoid huge interest outgo in the long run, together with the relief from maintaining credit and keeping a track of its repayment schedule, etc.

This is by far considered the most superior mathematical strategy to reduce one’s interest outgo across availed credit facilities. As per the strategy, one needs to first pay off the minimum sum across liabilities, and then begin to allocate extra funds towards debt with the highest interest rate (like credit cards, personal loans and other unsecured loans).

Snowball is another method to lessen interest burden and foreclose debt. Nonetheless, herein the borrower starts by repaying the lowest debt, which typically motivates him or her to continue the course.

CA Yogesh Birla, Director, Birla WP Management Co., explaining the 2 situations said, "There are two situations of foreclosure, either it is done voluntarily by borrower or it may be done by lender on default of a loan account. In second case it will obviously affect CIBIL in a very bad way and it will be very difficult to get new loan in future."

He added that if the foreclosure is done voluntarily by the borrower then it will have little negative impact in the short term due to reduced credit mix and credit history length stopped midway, but it will be considered good in long term CIBIL, which remains in record up to 7 years. Voluntarily foreclosure with good repayment history, disciplined EMI payments and sentiment of saving on interest cost favours CIBIL positively.

From the perspective of lending agencies, after a foreclosure, getting approved for new loans becomes tougher. Even if your loan is approved, you may be charged higher interest or tighter conditions for pre-closure, since interest on loans is major income of lender, so borrower shall take foreclosure decision based on saving of interest v/s foreclosure charges to be deducted by lender.

Though foreclosing loan accounts will help you significantly reduce your debt burden. Don’t opt for it as a whole, meaning to say, that one should not repay the debt at the cost of liquidity requirements for making investments such as in bonds or gold (for a higher return). Also, maintaining an investment portfolio based on your risk profile and investment goals is crucial for reaching a sizable corpus by the sunset years.

Further, you also need to strategically decide on the time of repayment, so as not to impact your credit score heavily.

Ravi Singh, MD & Founder, Airmoney Services noted that if EMIs are being paid on time, then a running loan actually helps the CIBIL score as it builds a good repayment track record. There is no need to foreclose the loan if the borrower is financially comfortable paying the EMIs regularly.

Further he added that If someone has surplus funds, they can consider foreclosure to reduce the overall interest burden. Usually, closing a loan after disciplined repayment does not negatively impact the credit profile.

For a borrower, the direct impact is seen in the debt-to-income ratio, which sees an increase. The debt-to-income ratio is the total debt you have, considering your income, and the lower the ratio, the better your credit score.

In this scenario, the benefit kicks in later in comparison, i.e. the credit score at first sees a decline due to lesser diversification in credit mix and shorter credit history. Nevertheless, in a case, if the credit utilisation ratio continues to be over 30%, the credit score gains within 6 months.

Best ways to foreclose a loan account without hurting credit score

1. Strategically plan loan closures, spread them across the timeframe, so that the dip in credit score is not large.
2. Always ensure that you receive the full-repayment NOC against the loan and don’t keep it as a ‘Settled’ loan obligation.
3. Also, for preserving your credit score, keep 1-2 credit cards, while adhering to the optimal utilisation for the best possible credit score.