Should you pay off your loan early or invest? Here’s how to decide

 I recently came into some extra funds and am considering repaying a portion of my loan early. How will this impact my credit score? Will it improve my financial standing in the long run, or should I use the funds for other investments instead? Are there any hidden downsides to early loan repayment, such as a negative effect on my credit history or liquidity concerns? I’d appreciate insights on how to make the best financial decision.

Reply by Akash Bararia, Head - Sales Finance, HDB Financial Services.

Paying off a loan early can be a financially empowering decision, but it’s essential to assess its impact on both your credit profile and long-term financial health before proceeding. 

Impact on Credit Score

Early loan repayment generally has a  short-term impact on your credit score. This is because:

Credit Mix Reduction – A well-maintained loan contributes to a healthy credit mix, which is a factor in your credit score. Closing it early might slightly reduce this mix.

Reduced Credit History Length – The longer your credit accounts remain active, the better it is for your score. Paying off a long-standing loan could shorten your credit history, though this impact is usually minor if you have other active credit accounts.

Improved Credit Utilization Ratio – If loan repayment reduces your overall credit exposure, it could positively influence your score, especially if you were utilizing a high percentage of your credit limit.

Financial Considerations

Beyond credit score implications, early repayment has broader financial consequences:

Interest Savings vs. Opportunity Cost

• Prepaying a loan saves you on interest payments, which can be substantial, especially in long-term loans like home loans. 

Liquidity & Emergency Planning

• Using surplus funds to pay off a loan should not come at the cost of depleting your emergency savings. It’s advisable to maintain at least 6-12 months of living expenses in liquid assets before making lump-sum repayments.

Prepayment Penalties & Loan Terms

• Some lenders impose penalties on prepayment, particularly for fixed-rate home loans. Review your loan agreement to ensure the savings from early repayment outweigh any penalties.

Tax Benefits Considerations

• If it’s a home loan, you might be claiming tax benefits under Section 80C (principal repayment) and Section 24(b) (interest deduction). Prepaying can reduce or eliminate these benefits, impacting your tax planning.

What should you do?

If your loan carries a high interest rate (like a personal loan or credit card debt), early repayment is usually beneficial.

If it’s a low-interest home loan and you have surplus funds, consider whether investing could generate better returns.

If loan repayment gives you peace of mind and improves financial stability, then clearing the debt could be the right choice, especially if you have no other liabilities.

Ultimately, the best approach is to strike a balance between reducing debt, maintaining financial flexibility, and ensuring optimal use of your funds. If needed, consult a financial advisor to align this decision with your long-term financial goals.

(The opinions expressed herein are solely those of the investment expert.)