After taking out a personal loan, you can use the funds for a wide variety of purposes. Many borrowers don’t realize that closing a personal loan is a formal process.
Understanding the types and conditions of loan closure can help you avoid unnecessary fees and penalties, complete the process successfully, and improve your credit score. Let’s review the essentials you should know about closing a personal loan.
Definition of loan closure
Closing a personal loan means that the borrower has successfully cleared all loan repayments and handed in any necessary documents upon loan closure. This process is also known as the loan payoff or termination.
Once your personal loan has been closed, that loan will be changed from “open” to “closed” on your credit report. All repayment terms have been satisfied.
There are many types of loan closure, which can affect the overall costs of your loan and your credit score.
Importance of closing a loan
Avoid loan default
Closing your loan on time helps you avoid late payments, and also prevents your loan from going into default. Defaulting on a loan can hurt your credit score, making it more challenging to obtain loans or credit in the future.
Pay off your debt
Paying off debt can alleviate your financial stressors. It also keeps debt collectors and lenders from chasing after you and ensures that any collateral you put up isn’t at risk.
Once you pay off a loan and close it successfully, you will no longer need to make monthly installments toward the loan. This enables you to budget more freely, aiming for other goals or paying off other debt.
Better credit score
One of the things that can improve your credit score is a loan closure. Closing a personal loan shows that you’ve successfully repaid debt, which can greatly boost your creditworthiness.
A higher credit score means that in the future, it should be easier for you to obtain a personal loan, especially a loan with more favorable terms and conditions. This means that you might be able to take out a loan with lower interest rates, longer loan tenures, and larger loan amounts.
Types of loan closure
Full loan repayment
You can close your loan under full repayment if you manage to completely repay your lender. This includes the interest accrued, additional charges, and the principal amount (which is how much you received in lump sum funds when you obtained the loan).
Typically, the loan is fully repaid at the end of the loan tenure.
Personal loan pre-closure
Also known as an early loan closure, pre-closure essentially has you repaying your loan before the due date.
Depending on your loan agreement, your lender might levy a penalty for pre-closing on your loan before your tenure is over. This pre-closure charge varies based on the lender as well as how much time ahead of your loan due date it is. The fee might be 2% to 5% of your outstanding principal balance.
Pre-closing a loan, despite the potential fees you might be charged, often comes with plenty of benefits. A loan pre-closure allows you to reduce your burden of debt, granting you more financial relief. It also allows you to save on interest, which can otherwise accrue significantly over the years. Finally, you might be able to improve your credit score.
Part loan prepayment
You may be able to part prepay your personal loan. A loan part prepayment means that you’re not paying off the entire loan in one go, but you are making a large, extra payment that reduces your debt.
Here are a few reasons borrowers might opt for a part prepayment:
- A bonus from work
- A surprise windfall gain has them more financially stable
- An inheritance
- They want to reduce how much they need to pay in interest
Online loan closure
Closing a personal loan online is relatively convenient and swift.
Note that personal loans are typically unable to be pre-closed online. If you close your loan early, expect to go through a lengthier process than if you go for a full loan repayment.
Offline loan closure
If you obtained an offline loan, you should expect to close the loan offline as well. This makes the process more complicated. It’s important to bring to your lender the various required documents to ensure proper loan closure, such as:
- The account number of your loan
- Your proof of identity (government-issued)
- Bank statements showing your last monthly installment
The lender will verify the validity of all the information you provide. They may charge a processing fee. It can be advisable to double-check with your lender that the loan has indeed been fully repaid. That way you won’t be penalized for failing to repay your loan later on when fees and interest have already accrued.
Pre-closure of personal loans
A personal loan can be closed before the loan tenure is over.
A great benefit of early repayment is that you can avoid paying as much money in interest. By aiming for the pre-closure of a loan, you might make numerous extra payments to repay the debt faster, or you might make one giant payment to finish the loan off.
Early repayment can grant you more financial freedom, so you no longer need to worry about needing to make regular payments each month.
However, it’s important to know about potential penalties and disadvantages that are associated with a personal loan pre-closure. If you close your loan early, there might be a prepayment penalty.
Each lender has their own terms and conditions for what happens if you decide to close your loan early. If you are already considering early repayment of your loan before signing a loan agreement, make sure you review the terms and conditions of your loan to see what prepayment penalties and fees you may be charged.
Procedure for closing a personal loan
When you close a loan, your lender might require you to provide a certain set of documents. First, make sure that you have the requisite documents and proof on you.
The lender might require you to fill out forms or write a pre-closure request letter if you are pre-closing (i.e. closing the loan early).
If you’re pre-closing, after you pay the pre-closure amount and any required fees or penalties and sign any necessary documents, your loan will be closed.
Closing can be done either online or offline depending on your lender and loan. A settlement agent might walk you through the process, answering any pertinent questions you might have about the loan closure procedure.
Documents required for loan closure
Requirements can vary, but here are the typical kinds of documents that a lender might request from you:
- Statement of the final loan payment
- Loan account number
- Proof of identity
Charges associated with loan closure
Oftentimes, pre-closure fees and part prepayment fees are equated as the same kind of fee. Both are penalties that happen if you pay off your loan early, whether that’s the loan's entirety or a part of it.
If you pre-close a loan, which means you finish paying off your loan early, you might need to pay a fee. This is because the lender could have lost a substantial amount in interest you would have paid over the life of your loan, and the fee helps recoup the lender’s losses.
Pre-closing a loan can result in a charge that is under 10% of your loan’s outstanding balance when you opt for the pre-closure process, a fixed fee, or the cost of interest on your remaining loan term.
Part prepayment fees
Making extra, early installments to repay your loan might result in part pre-payment fees. A part prepayment fee may be a fixed amount. It can also be either a small percentage of your outstanding loan principal or accrued interest costs on your remaining loan term.
How do I know if there is a prepayment penalty?
Lenders are legally required to disclose any prepayment penalties they impose. This information should be in the fine print of your loan agreement, so make sure to review your agreement for important information.
Some loans are more regulated or strict, making prepayment penalties illegal. If you obtained one or multiple of the following loans, you can expect to be free from paying prepayment fees:
- Department of Veterans Affairs loan
- Federal Housing Administration loan
- U.S. Department of Agriculture loan
- Student loan
Impact of loan closure on credit score
Closing a loan positively affects your credit score, which is a three-digit number that conveys your creditworthiness. Closing a loan successfully can boost your credit score. Your credit score might go up 10 to 50 points, or another amount based on your individual circumstances and credit history.
Whereas a loan default can hurt your credit score for 7 years, repaying your loan successfully will positively influence your credit score for up to 10 years. Generally, closing a loan is great for a person’s credit score–if you can afford to comfortably pay off debt, it is often a beneficial choice.
In some cases, you might see your credit score dip slightly after you pay off a loan. This will usually fix itself and you can expect to see it rise after it is adjusted for your new credit status and creditworthiness.
Having a good credit score isn’t just advantageous for you, personal loan-wise. It can also help you secure financial benefits in other areas of your life. Lenders that weren’t previously willing to lend you money might accept your new loan applications.
What happens to my credit score if I pay off a personal loan early?
It depends. A personal loan with regular installments that gets paid off will be shown as “closed” on a credit report. This means that even if your credit score should go up after closing a loan, it might not go up as much if you pay the loan off early. This is because an “open” account with on-time, regular payments may have a greater positive impact on your credit score.
Consequences of defaulting on loan closure
A loan goes into default if there are no attempts at repaying it for a period of time (usually a few months). If you default on a personal loan, this could have disastrous credit and financial consequences.
Secured loan default consequences
Loans like mortgages and auto loans are secured by collateral, which are assets you choose to offer up to the lender. If you default, the lender can legally seize your collateral.
Defaulting on a secured loan can seriously hurt your credit score, affecting your credit report for up to 7 years.
Unsecured loan default consequences
Despite not having collateral, unsecured loans still come with serious consequences if you don’t close the loan and pay off the debt. Your lender (or a debt collector) may take you to court to recoup their losses. They may charge you collection fees, contact you by email or phone, and otherwise try to persuade you to pay off the outstanding balance.
Defaulting on an unsecured loan can damage your credit score, appearing on your credit report for the next 7 years.
Tips for successful loan closure
- Figure out if it’s better to pre-close your loan
Pre-closure can help you avoid accruing more costs in interest, but it may come with prepayment fees and penalties.
For many borrowers, if it makes sense and is possible to close a loan early, it is still worth doing so. The credit impact is not often a determining factor in the ultimate choice. In both cases of a regular full loan closure and a pre-closure, the credit score should go up. Your financial burden may go up or down based on various factors, such as whether there is a prepayment fee.
When it comes to credit and personal loans, it’s advisable to reflect upon your own situation and make the decision that suits your needs best.
- Be proactive if you might default
If you think you might default on a loan, it might be worth reaching out to your lender to work out a new repayment plan. Many lenders are willing to be lenient to devise a schedule that works for borrowers so that they can ultimately be repaid in full.
- Review your loan agreement carefully
Your loan agreement includes essential information, such as whether there are fees for pre-closure or pre-payment. A prepayment clause will designate whether your lender charges a prepayment fee, how much it is, and when it is necessary.
Not every personal loan comes with a prepayment penalty. Make sure you are aware of your lender’s terms and conditions when you obtain a loan.
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