Is Paying Off A Personal Loan Early A Good Idea?
6-Minute ReadDecember 29, 2021
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. This article will explain when paying off a personal loan early would make sense, and when you should direct your extra payments elsewhere.
Can You Pay Off A Personal Loan Early?
If you have enough money to make an extra payment or two, then 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, including having other higher interest debts, prepayment penalties for the loan or higher priority expenses and investments, all of which we’ll discuss further down in the article.
Before you decide to put some extra cash toward your personal loan, consider first 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:
- 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 anything you want.
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 almost certainly 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.
The Benefits Of Paying Off Your Personal Loan Early
With all this in mind, consider the following benefits to paying off a personal loan early.
You Can Pay Off A Loan Early To Avoid Interest
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 may pay in interest. You can save hundreds of dollars if you pay off your personal loan 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 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 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 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.
Paying Off A Loan Early Can Lower Your DTI
Your debt-to-income (DTI) ratio calculates the amount of your income that goes toward your monthly 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 By Paying Off A Loan Early
Having a month-to-month budget plan can simplify having the money to afford all your monthly payments, as well as day-to-day expenses. Freeing up the money that would normally go toward your personal loan can give your monthly budget a boost. You could put that extra money toward other debts, invest it or save for retirement.
Reasons Not To Pay Off A Personal Loan Early
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. Let’s take a look at why below:
You Have Other Debts To Consider
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 loans, then it might make more sense to take that extra money and 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%. You might want to pay those more expensive debts off before you worry about your personal loans.
You Want To Build An Emergency Fund
There are other times when it's better to skip paying off your personal loan early. For instance, if you don't have an emergency fund, it could be 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 your car's transmission fails.
Experts say you should have from 6 – 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 pay 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, 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.
Prepayment Penalties For Paying Off A Loan Early
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 5 years. Your lender might charge you 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 less than the full 5 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 possible to avoid these penalties. Try to work only with lenders that don't charge them. There are plenty of personal loan lenders and lending platforms that don't levy prepayment penalties – Rocket Loans℠, for example.
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.
Does Paying Off A Loan Early Hurt Your Credit?
Paying a loan off early is one of the many ways a personal loan can affect your credit, in this case causing it to drop slightly.
When you finish paying off a personal loan, that account then closes. Since your FICO® Score is heavily influenced by your credit history, closing that account can shorten the length of your history and, consequently, your credit score. Closing the account can also make your credit mix less diverse, another factor in your overall score.
How much your score goes down can depend on your overall credit profile, but as long as you’re keeping up with your other monthly payments, the drop should only be temporary.
If you can pay off a personal loan early, it might make financial sense to do so. However, it may not be the best decision for everyone.
Take a close look at your personal finances. Whether paying your loan off early would work in your favor can depend on your loan's interest rate, how much you owe in other debt and how prepared you are for a financial emergency.
Want more advice for paying off your debt? Learn what mistakes to avoid as you work to pay your loans down.
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