- Paying off a personal loan early can save you money on interest, but you have to be careful when it comes to prepayment penalties.
- It’s also possible that paying off debt ahead of schedule could temporarily ding your credit score, so time an early payoff carefully if you’re looking to obtain credit in the near future.
- Take the time to confirm that paying off your loan early won’t harm your savings to the point that you wouldn’t be able to afford an unforeseen, future expense.
While paying off a personal loan early when possible may seem like the obviously right path to take, that isn’t always the case.
Sure, if you have spare room in your budget to make extra payments, you can cut the amount of interest you would owe to your lender.
However, former financial planner Michael Ryan notes that there are some instances where it might not make sense to pay off your personal loan early. “If you have a low interest rate, you may not save much money in interest by paying off the loan early,” says Ryan. “Additionally, if you need the money for other purposes, it may be better to keep the loan and use the extra money for other expenses.”
Keep reading for more insight into the pros and cons of paying off a loan early.
Inside this article
What to know before paying off a personal loan early
Before you move forward with paying off a loan early, it helps to know what factors you need to weigh in order to make an informed decision.
These are some of the main pros and cons of an early payoff worth keeping in mind.
- Interest rate savings: The faster you pay off a personal loan, the fewer interest payments you’ll make.
- Reduced debt-to-income ratio (DTI): This can make it easier to qualify for new credit products.
- Loan payments can cover other costs: If you pay off a personal loan early, you free up room in your monthly budget to cover other expenses.
- Prepayment penalties: Some lenders charge a fee if you pay off your personal loan early. Double check your loan agreement to see if you risk being charged a prepayment penalty.
- Can eat up savings: Making extra payments each month or making a large lump sum payment in order to pay off your loan early can cause financial strain.
- Credit score may suffer: If you make loan payments on time, your credit score actually benefits from having credit products like personal loans open.
When it might make sense to pay off your personal loan early
It makes the most sense to pay off your personal loan early if doing so won’t cause you any financial strain and if you stand to save money on interest.
If you’re trying to improve your credit score before applying for a new form of credit like a mortgage, you may want to hold off on paying off your personal loan since doing so may temporarily lower your score. If you don’t need to apply for credit any time soon, you can rest easier knowing you’ll have time to improve your credit score before applying.
Here are a couple of scenarios in which an early payoff might make sense:
When you need to decrease your DTI ratio: While it helps to keep older credit accounts open (to keep your credit score high) before applying for new credit products, if your DTI ratio is too high, lenders won’t feel comfortable lending you money for fear of you not being able to afford repayment.
If debt causes you financial stress: Ryan says that most financial advisors suggest you keep your money invested and maintain your loans, but when he had a client whose debt was causing her a lot of stress, he advised her to pay it off. Sometimes the emotions trumps the math. If paying off your debt helps you sleep better at night, says Ryan, that can be worth more than potentially earning money off investments.
If you can refinance your loan to friendlier repayment terms: Refinancing a personal loan means taking out a new debt to pay off your old one. It could be a beneficial strategy if it delivers a lower interest rate or a more affordable monthly payment with a better lender. (Sound Dollar reviewed top personal loan lenders.)
Generally, these are some steps you can take to pay off your personal loan early.
|1. Check for a prepayment penalty||Because lenders make money by charging interest, some also charge prepayment penalties if you pay off your loan early. Double check your loan contract to see if there is a prepayment penalty—it could be anywhere from zero to 8% of your loan balance—so you can weigh if you’ll save enough on interest for this move to make sense.|
|2. Request a payoff statement||Your final payoff amount can be more than just your current balance due to prepayment penalties and the interest that will accrue until the day you make your final payment. Ask the lender for what the exact amount you need to pay off is—they have to provide you with a written statement of that amount and what day it needs to be paid by to completely pay off the loan.|
|3. Make extra loan payments||You may want to increase your monthly payments until you pay off a loan in full, or you may decide to make one final lump sum payment. Make sure any extra payments you make are going towards the principal loan balance, not the interest.|
When it might not make sense to pay off your personal loan early
Even though it can feel really good to be debt-free, there are times when it doesn’t make sense to pay off a personal loan early. Maybe your lender imposes a costly prepayment penalty, for example. Or perhaps paying off the loan early could leave you too little margin for error in your budget.
Here are a couple situations in which it might be more sensible to stick to the originally planned repayment schedule:
When you want to invest: As noted above, if you have the money to pay off a loan early, you may be better off putting that money into investments and sticking to your original repayment plan. You may stand to earn more by investing than you would spend on the loan’s interest. (If your personal loan interest rate is in the single digits, for example, and you expect the average stock market return of 10%, it might behoove you to invest.)
If prepayment would eliminate your emergency fund: Having an emergency fund in place can help you avoid turning to high interest debt like credit cards and payday loans when you’re hit with an unexpected large expense like a medical bill or car repair.