You can always decide to pay a personal loan off before its scheduled term expires. If you’ve recently come into a significant sum of cash and you can pay off a personal loan early, it may seem like the prudent, fiscally responsible thing to do.
However, in some cases, paying off your personal loan early isn’t the best way you can use your available funds. In some circumstances, you’d actually benefit from continuing to make monthly payments instead of paying it off early and closing the account.
Benefits of Paying Off Your Personal Loan Early
Paying off a personal loan early can be the right move in certain situations, and offers several potential personal and financial benefits that are worth considering.
1. You’ll Have Extra Cash Each Month
When you pay off a personal loan early, you save all the future interest payments you would have made.
Let’s take a simplified example.
If you had taken out a three-year loan at 10% interest in the amount of $9,000 and have paid back $3,000 of it already, you now have a balance of $6,000 remaining.
Your total interest over the life of the loan would have originally been $2,700. Paying off the remaining balance would save you $1,800 in interest payments.
You can put the money you’d have spent on each month’s payment towards different or bigger priorities. You could start investing or pay down other debt. Consider adding more to your retirement savings or building up your emergency fund if you don’t have one already.
2. You Might Improve Lenders’ Perception of Your Credit Risk
Paying off your personal loan early might improve your chances of getting additional credit on better terms down the road, either from the same lender or a different one.
Here’s why: Add up the total amount of all your debts and divide that total by your income. The figure you get is your debt-to-income ratio and it’s a significant factor used by lenders to determine how big of a credit risk you are. Lowering that ratio by paying off a loan balance will help improve your chances of qualifying for more credit at better terms.
3. You Can Reduce the Financial Stress of Carrying Debt
You’ll reduce your stress levels. For some folks, carrying debt and making monthly payments is a huge source of anxiety. If that’s you, paying it off early is a great way to increase your peace of mind. Just make sure that you have a fully funded emergency account and enough income to cover your expenses.
Drawbacks of Early Repayment for Personal Loans
It might seem counterintuitive. After all, isn’t paying off debt a good thing for your finances and your credit? The answers are a bit more complex than they might seem initially.
1. You Might Owe a Prepayment Penalty
Generally, you can always pay off a personal loan early, although some loan terms will call for a prepayment penalty.
These clauses are not uncommon. Lenders often include prepayment penalty clauses in order to help offset the loss of interest when you pay off your loan early. This penalty may be more than what you’d save by paying early, especially if it’s a low-interest fixed rate loan.
Read your loan documents carefully to look for any clauses that bear on prepayment, and if it’s not clear, call your lender to verify.
If there is a prepayment penalty it may not be worth paying the loan off early.
2. You Might Be Missing Out on a Credit-Building Opportunity
If you pay off a personal loan early you could affect your credit history. When you pay a personal loan off early, you’re losing out on all the remaining scheduled payments. Since making scheduled payments consistently over time is a positive factor for your credit rating, eliminating those future payments is a missed opportunity to raise your credit score.
Active accounts have more impact on your score than closed accounts, so making on-time payments for the balance of your loan term will do more for your credit than paying your loan off and closing the account.
3. There Might Be a Better Use for Those Funds
You might be able to make the cash you’d spend paying down your loan go further with a different choice. If you’re carrying debt with a higher interest rate than the loan, you’d be better off paying that debt down or paying it off completely. You’d wind up saving more money in interest payments.
This is often the case with credit card accounts, which currently carry average interest rates of anywhere from 15% to 19%. The average personal loan interest rate is 9.41%, considerably lower.
You may also be able to invest that money and gain opportunities you wouldn’t otherwise have. Consider all other options before putting money into paying a loan off early.
Will You Hurt Your Credit if You Pay Off a Personal Loan Early?
Prepayment of personal loans won’t improve your credit the way paying off a credit card balance does. That’s because the two kinds of accounts are treated differently by credit agencies.
Credit cards are revolving accounts, meaning your balance revolves monthly. You can pay that balance off completely, but the account stays open. There’s still available credit open to you through that account, assuming it’s still in good standing. That means paying off the balance lowers your credit utilization rate and consequently raises your credit score.
Personal loans are installment loan accounts. Once you pay off the balance of an installment loan account, you’ve met your obligations under the loan terms and the account is closed. There’s no more available credit to you on that account, so your credit utilization rate isn’t lowered. That’s why it doesn’t have much, if any, impact on your credit score.
How to Pay Off Your Personal Loan Early
If you think it might be a smart financial move to pay off your personal loan early, it’s best to go about it strategically and thoughtfully. Follow these steps to evaluate your options and make the best decision for you, based on your goals and preferences:
- Run the numbers. List out your other consumer debt accounts and potential investments. Compare interest rates and their impact on the total amount you’d either lose or gain. You don’t necessarily have to be ruled by the math but you should know what the costs are.
- Evaluate your tolerance for carrying debt. If it stresses you out to make monthly payments, paying it off might be worthwhile, even if there’s a prepayment penalty.
- Take a look at your current credit reports and score. If it needs some work, it might be better to keep making payments. If you’re satisfied with it, paying the loan off early might help you achieve other financial goals.
- Shore up your emergency savings. Before you repay your loan, make sure you have an emergency fund equal to several months’ worth of expenses saved first. If unforeseen difficulties develop after you pay off your loan, you won’t have to go back into debt to cover the necessities.
- Examine other consumer debt you’re carrying. Once the emergency fund is saved, next take a close look at the terms of all the debt you’re currently carrying. If you’ve got a credit card with a higher interest rate attached to it than the one for your personal loan, it makes more sense to pay off that balance first.
- Analyze possible investment options. In the same vein, consider possible investment options. Could you get a higher rate of return if you invested that money instead of paying off your loan? If so, that would be a smarter cash management move.
If paying off your personal loan is the right move for you now, then ask for a payoff amount from your lender and submit your payment. Keep accurate copies of all documentation for this loan on file in case issues arise later.