Can I Pay Off My Personal Loan Early?
You still have a year of monthly payments left on that personal loan you took out three years ago. But now you have some extra cash saved up – enough to pay off that loan early. Should you do it?
That depends. You'll have to look at the interest rate attached to your personal loan, the size of your loan's monthly payment, the other debts you owe and how much money you have stashed away for emergencies.
Paying off a personal loan early is a huge accomplishment that makes sense for many. But it's not the right choice for every borrower. Let's see if paying off your personal loan early makes sense for you.
The Benefits Of Paying Off Your Personal Loan Early
A personal loan works much like any other loan product. Here are the basics:
- You’ll borrow a set amount of money from a lender, who will provide you that money in a single lump sum.
- You then pay the loan back over time in monthly installments.
One of the biggest benefits of personal loans is that it's personal: you can use them for almost whatever you want. You can use the funds from a personal loan to pay off debt with higher interest rates, help pay for a home remodel project or help you cover the costs of something special like your wedding.
Personal loans, though, do come with a cost. Your lender will charge interest or APR on the money they’ve lent you, so you’ll pay back more than what you originally borrowed. Interest is how the lender makes a profit on the money they’ve lent you. That interest rate will vary depending on your credit score, but typically ranges from 4.99% to as high as 28%.
Generally, the higher your three-digit credit score, the lower your interest rate. The interest rates on personal loans are typically higher than what you’d see on mortgage or auto loans because most personal loans do not require collateral.
If your interest rate or APR is high, you'll pay a lot more to borrow that money. That's why paying off a personal loan early often makes financial sense: The sooner you pay it off, the less you'll pay in interest. You can save hundreds of dollars if you pay your personal loan off before its official due date.
Say you take out a personal loan for $5,000 with a 3-year term at an interest rate of 5.95%. If you take a full three years to pay off that loan, you’ll pay slightly more than $471 in interest. If you took that same loan and paid it off in two years, you'd pay about $315 in interest.
The figures get higher, of course, if you borrow more money at higher interest rates and longer terms. Say you take out a $10,000 personal loan at an interest rate of 7% with a 5-year repayment term. You'd pay about $1,880 in interest if you took the full five years to pay that loan back. If you instead paid that loan back in three years, you'd pay about $1,115 in interest. Now that's a significant savings.
OK. So Why Wouldn’t I Pay Off My Personal Loan Early If I Can?
Saving money on interest is a smart financial move. But this doesn’t mean that everyone who can pay off their personal loans early should. For some people, this isn’t the best decision.
Consider Your Other Debts
While the interest rates on personal loans are higher than those you’d find on mortgage or auto loans, they’re lower than the rates consumers typically get with their credit cards, car title loans or payday loans.
If you owe a significant amount on your credit cards or if you’re paying off payday or car title loans, then, it might make more sense to take that extra money and pay off these higher-interest-rate loans or debt first.
Think of it this way: A personal loan with an interest rate of 7% will cost you less than $4,000 worth of credit card debt at an interest rate of 20% or a payday loan with an interest rate of 18%. Pay those more expensive debts off before you worry about your personal loans.
Do You Have An Emergency Fund?
There are other times when it’s better to skip paying your personal loan early. For instance, if you don’t have an emergency fund it’s better to take your extra cash to build one.
An emergency fund, as its name suggests, is a pool of money that you only dip into to cover the costs of unexpected emergencies. This way, you won’t have to run up debt on your credit cards if your water heater bursts or car’s transmission fails.
Experts say you should have from 6 to 12 months of daily living expenses saved in your emergency fund. If you don’t have this, it might be better to build that fund than it is to pay off your personal loan.
A Lot Depends On Your Personal Loan’s Interest Rate
You might be able to make money by investing the dollars that you’d spend on paying off your personal loan. Of course, this all depends on your loan’s interest rate.
Maybe you can sink your money in the stock market and earn a return of 8% on your dollars. That might be a good move if your personal loan’s interest rate is only 5%. You’d make more than you’d save by paying off your loan.
But what if the interest rate on your personal loan is higher, such as 15%? You’d struggle to find an investment vehicle with a return anywhere near that level. In such cases, it’s better to pay off your personal loan early.
What About Prepayment Penalties?
There’s one more factor to consider when determining if paying off your personal loan early makes sense: Does your loan come with a prepayment penalty?
As the name suggests, some lenders charge this penalty if you pay off your loan too early. Say you take out a personal loan with a term of five years. Your lender might charge you a prepayment penalty if you pay off that loan in three years or less. Others might charge a prepayment penalty if you pay it off in less than the full five years.
Prepayment penalties can come in different forms, depending on lenders. Some might charge a percentage of your balance. Say you owe $2,000 on your personal loan and you pay it off early. A lender might charge you 2% of your balance, or $40, as a prepayment penalty. Others might charge you a certain number of months of interest. Say you were paying $20 a month in interest. A lender might charge you 6 months of interest, or $120, as a prepayment penalty.
Still others might charge you a flat fee if you pay off your loan early.
Fortunately, it’s easy to avoid these penalties. Work only with lenders that don’t charge them. There are plenty of personal loan lenders that don’t levy prepayment penalties.
And if your lender does charge one of these penalties, decide if the financial hit of the penalty will outweigh the savings in interest you’d realize by paying your loan off early. If it does, it might make sense to skip paying your loan off early.
There are plenty of good reasons to take out a personal loan. And like most debt, if you can pay off your personal loan early it usually makes financial sense. But as is so often the case with financial decisions, there is no one-size-fits-all answer.
Sometimes you should resist the temptation to pay off that personal loan early by taking a close look at your finances. It all depends on your loan’s interest rate, how much you owe in other debt and how prepared you are for a financial emergency.
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