Does Paying Off A Loan Early Hurt Your Credit?

Let’s say you have a year of monthly payments left on a personal loan you took out 3 years ago. You’ve managed to save up some extra cash – enough to pay off that loan early. Should you do it?

Paying off a personal loan early can be a huge accomplishment that makes sense for many, but it may not be the right choice for every borrower. Sometimes, paying off a loan early can even hurt your credit.

Let’s take a closer look at when paying off a personal loan early makes sense, and when you’d be better off directing your extra payments elsewhere.

If you have enough money to make an extra payment or two, you may be able to pay off a personal loan earlier than planned. Certain factors could affect your ability to make extra payments on a loan, like prepayment penalties for the loan and higher-priority expenses and investments – all of which we’ll discuss a little later.

Before you decide to put some extra cash toward your personal loan, first consider how paying the loan off early can affect you and your finances.

The Costs Of A Personal Loan

A personal loan works much like any other loan product:

1. You’ll borrow a set amount of money from a lender, who will provide you that money in a single lump sum.

2. You’ll pay the loan back over time in monthly installments.

One of the biggest benefits of a personal loan is that you can use it for almost anything you want. This kind of loan comes with a cost, though, in the form of interest. It’s by charging interest that the lender makes a profit on the money they’ve allowed you to borrow, and your interest rate is determined in large part by your credit score. The interest rate for a personal loan is typically 6% – 36%.

Generally, the higher your three-digit credit score, the lower your interest rate.

Paying a loan off early is one of the many ways a personal loan can affect your credit, in this case causing your credit score to drop slightly.

When you finish paying off a personal loan, the account closes. Since your FICO^® Score is heavily influenced by your credit history, closing the account can shorten the length of your history and, consequently, impact your credit score. Closing the account can also make your credit mix less diverse, another factor in your score.

How much your score goes down can depend on your credit profile, but the drop should only be temporary as long as you’re still making on-time monthly payments. With that in mind, weigh this potential effect on your credit report against the benefits that come with paying off a personal loan early.

Early repayment of a personal loan may temporarily hurt your credit, but it’s important to consider the long-term advantages of paying off a personal loan ahead of time.

You Can Save On Interest

If your interest rate or annual percentage rate (APR) is high, you’ll pay a lot more to borrow  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.

Let’s say you get a personal loan for $5,000 with a 3-year term at an interest rate of 5.95%. If you take a full 3 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 2 years, you’d pay about $315 in interest.

The figures get higher, of course, if you borrow more money at higher interest rates and for longer terms. Let’s 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 5 years to pay that loan back. If you instead paid that loan back in 3 years, you’d pay only about $1,115 in interest – a significant difference in savings.

You Can Lower Your DTI

Your debt-to-income ratio (DTI) is the amount of your income that goes toward your monthly debt payments. Paying off a personal loan early can lower that ratio, and having a lower DTI can make you eligible for better interest rates on other loans.

You Can Increase Your Budget

A month-to-month budget plan can help ensure you have the money to afford all your monthly payments and day-to-day expenses. Freeing up the money that would normally go toward your personal loan can give your monthly savings or budget a boost. You could also put that extra money toward other debts, invest it or save for retirement.

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 do it. For some people, this isn’t the best decision. Below, you’ll see some of the reasons why.

You Have Other Debts To Consider

While the interest rates on personal loans are typically higher than those on mortgage or auto loans, they’re lower than the rates typically available with credit cards, car title loans and payday loans.

If you owe a significant amount on your credit cards or loans, it might make more sense to pay off those debts 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%. It’s best to pay those more expensive debts off before worrying about your personal loans.

You Want To Build An Emergency Fund

If you don’t have an emergency fund, that’s another instance where it’s best to skip paying off your personal loan early. Instead, take your extra cash to build an emergency fund.

An emergency fund, as its name suggests, is a pool of money that you only dip into to cover unexpected expenses. This way, you won’t have to accrue credit card debt paying for emergency medical bills or car repairs.

Most financial experts say you should have from 3 – 6 months of daily living expenses saved in your emergency fund. If you don’t have this, building that fund might be better than paying off your personal loan.

You Could Invest The Extra Money

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, maybe 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.

Some lenders may charge a prepayment penalty if you pay off your loan too early. If, for example, you take out a personal loan with a term of 5 years, your lender might charge a prepayment penalty if you pay off that loan in 3 years or less. Others might charge a prepayment penalty if you pay it off in any amount of time less than the full 5 years.

Prepayment penalties can differ by lender. Let’s 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’ interest. If you were paying $20 a month in interest, for example, 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 possible to avoid these penalties. Try to work only with lenders that don’t charge them. Numerous personal loan lenders and lending platforms, including Rocket Loans℠, don’t levy prepayment penalties. If your lender does charge one of these penalties, decide whether the financial hit of the penalty will outweigh the savings in interest you could earn by paying your loan off early. If it does, paying your loan off ahead of schedule doesn’t make financial sense.

Will my credit drop if I pay off a loan?

Yes, your credit score can drop after closing a loan account, but only temporarily. Continuing to make monthly payments on other debts will bring your score back up over time.

Is it smart to pay off a car loan early?

Paying any loan off early can save you money in interest and free up funds you can put toward other expenses or savings. Some borrowers who can afford extra payments on a loan may instead put their money elsewhere. Every borrower has a different financial situation that can affect whether they decide to pay a loan off early. 

What kind of loan will not have a prepayment penalty?

Federal law prohibits lenders from issuing prepayment penalties on certain types of loans, including most government home loans and student loans. Rocket Loans doesn’t charge a prepayment penalty for personal loans.

If it’s possible to pay off a personal loan early, it might make financial sense to do so. However, it may not be the best decision for you. Take a close look at your personal finances. Whether paying your loan off early would work in your favor will largely depend on your loan’s interest rate, how much you owe in other debt and how prepared you are for a financial emergency.

Still deciding whether to seek a personal loan? Get prequalified today with Rocket Loans to see your potential rates and terms.