If you have a personal loan, paying it off early can reduce your monthly expenses and save you from paying more in interest.
However, having a personal loan paid off early may also come with unintended consequences. It can impact your credit score, cost you hefty prepayment penalties or prevent you from using that extra cash to grow your savings.
Start by assessing your financial health. Then, explore alternative options before deciding if paying off your personal loan early is right for you.
Can You Pay Off a Personal Loan Early?
You can pay off a personal loan early, but it could cost you extra money depending on the lender.
If you pay off your loan ahead of schedule, your lender may lose out on interest you would’ve paid if you followed the original repayment schedule.
For that reason, some lenders charge a prepayment penalty. Since you’ll avoid interest payments on the loan, prepayment penalties ensure the lender still makes money.
Most prepayment penalties are 1% – 2% of the loan amount, which can be hefty depending on how much you borrowed. So before you pay off your loan early, check with your lender to see if there’s a prepayment penalty in the loan agreement.
Not every lender charges a prepayment penalty, and it’s something to keep in mind if you plan to take out a personal loan.
Will Paying Off a Personal Loan Early Hurt My Credit Score?
While paying off debt is a good thing, depending on your financial situation, paying off your personal loan early can negatively impact your credit score.
This is because your credit score is based on factors like:
- Your credit mix: This includes which types of debt you have.
- Credit utilization rate: This is how much you owe compared to your available credit.
- Your credit history: This considers how long you’ve had certain loans.
10%
of your FICO score is based on your credit mix.
For example, if you have a personal loan you’ve been paying for 3 years and several recently opened credit cards on your account, the personal loan helps improve your credit mix and credit history. If you pay off the personal loan prematurely, your credit score may go down.
When the account closes – if you don’t have other installment loans, like a home loan – the number of on-time payments on your credit history will drop. In addition, the loan won’t appear on your credit report for very long, hurting your credit history.
Take into consideration that you may lose points on your credit score, since open accounts weigh more heavily than closed accounts when factoring your FICO score.
What Are the Pros and Cons of Paying Off a Personal Loan Early?
Paying off debt early is a great way to have more money each month. However, consider your financial situation before deciding to pay off your personal loan prematurely.
✅Reduce debt
If your goal is to be debt free, paying off your personal loan early is a great way to do that. You can then roll your savings from the personal loan payments to your next debt account.
✅Save money on interest
Interest can add to your overall loan amount, so paying it off early can save you money.
✅Lowering your debt-to-income (DTI) ratio
Your DTI ratio is the amount of debt you owe versus your monthly income. Paying off your loan early reduces your monthly debt payment, which can improve your DTI ratio and make it easier to qualify for things like a home loan.
✅More money in your budget
The less money that goes out, the more money in your account. Ending your monthly loan payment will help grow your budget for investing, retirement or your family – whatever you want!
⛔Prepayment penalty
You may face a prepayment penalty for paying off your loan before the loan’s terms. It’s not a common practice anymore, but it can cost you a hefty price.
⛔Credit score could go down
Closing an installment loan can harm your credit score if you have a short credit history, it increases your credit utilization ratio or if you need more on-time payments to remove delinquencies from your credit report.
⛔Missed opportunities to pay down debt, save or invest
Consider your debt repayment strategy. Often, it’s better to pay down high-interest credit cards before loans with lower interest rates. Look into investment options if the return is higher than the interest on your personal loan.
Is It a Good Idea To Pay Off a Personal Loan Early?
Whether or not it’s good to repay a personal loan early depends on your financial goals. Using extra cash to pay down debt is an effective financial strategy.
Keep in mind there are alternative strategies to consider putting your money toward.
For example, if you’re a recent college graduate with no savings and only a few accounts – like student loans and low-balance credit card debt – paying off the loan early can help you build savings and improve your credit history.
Meanwhile, for someone who’s established in their career, has excellent credit, savings set aside, no repayment penalty and is looking to get out of debt, paying off a personal loan early is a great strategy.
Things to consider before paying off a personal loan early
Debt, and deciding whether to pay it off, is a tricky game – especially as you consider all of your financial goals, such as retirement and savings.
Assuming you’re able to make your minimum loan payments, there may be other ways to put your money to use. For example, instead of paying off your loan, you could:
- Set aside 6 – 12 months of expenses to avoid going back into debt if you lose your job.
- Invest your money in a retirement fund or college savings for kids.
- Invest in real estate or other investment opportunities with a higher rate of return.
Go With Your Gut
Only you know what’s right for your financial goals. Evaluate different strategies and consider if paying your personal loan off early will help your monthly budget or hurt your credit score.
Weighing your options and checking for a prepayment penalty will help you make the best financial decision.