Does Paying Off a Loan Early Make Sense?

Personal loans can be a great way to take care of financial challenges, but they come at a cost. Some loans have high interest rates, others may have terms that can carry a penalty for early repayments. But there are many situations where it can make sense to pay off a loan early. 

Being familiar with your loan agreement and knowing what to look for is where to start. There are some situations where paying off your loan early can make sense, and other scenarios where it might not. Read on to look at all the angles so you can determine which is the right move for yourself.

Is It an Option to Pay Off a Personal Loan Early?

In most cases it’s an option to pay off a loan early, but sometimes there can be prepayment penalties. Looking within the terms of your agreement is a good place to start. Most loans do not carry a penalty for early repayment, but it’s important to check your terms and not assume. Even if there is a penalty for paying a loan off early, it is worth running the numbers. Sometimes it can be more beneficial to take the hit and pay the penalty than continuing with the scheduled payments. 

Depending on the terms of your loan agreement, a penalty can vary. Some might charge a penalty of maybe 2% if you were to pay the loan off within 6 months of disbursement, and others might charge a penalty if paid early anytime before the term has ended.

Types of Prepayment Penalties

A prepayment penalty on a loan can be a percentage of your balance, fixed fee, or it can be interest based. Understanding the difference can help you determine whether paying early makes sense.

Flat fee – this is a set amount and is not affected by the remaining balance on the loan

Interest based – this is the amount of interest that your lender would be missing out on if you were to you pay off the loan early.

Percentage of balance – some lenders use a percentage of balance and often about 1 to 2%, and as much as 5%. Depending where you are in the term of repayment the amount will vary.

With the exception of a flat fee penalty, if you are early in the term of your repayment plan it will always be more expensive this the other types of prepayment penalties are based on a percentage of the balance.

RELATED: Does Your Personal Loan Have A PrePayment Penalty? 

Pros of Paying Off a Personal Loan Early

By far the biggest advantage to paying your loan off early is the money you would save that would otherwise go to interest payments. Should you choose to pay your loan early, you can use that extra money for smart money moves like building up your emergency fund, paying down other debt or putting more money towards your savings. Paying off early is also beneficial as it would lower your credit utilization ratio, which is about 30% of your credit score. It also would help with maintaining your credit history, which is based on on-time (or late) payments made and makes up the largest part of your credit score at 35% towards your overall rating.

RELATED: How a Personal Loan Can Help You Save Money 

Cons of Paying Off a Personal Loan Early

If you were to put everything towards paying off your loan early, in some cases it can leave you in a jam. Should something come up like repairs or other unexpected expenses, you may find yourself searching for ways to cover costs. Additionally, using extra money that might be put to better use like when you could get better returns is another way of determining where you might want to place your money. 

RELATED: Tips to Manage Personal Loan Payments 

Does Paying Off a Loan Early Affect Your Credit?

You may find your credit score drops a little, but it usually returns to its previous position in a short amount of time. How your credit report responds to early payment of your loan can also depend on whether you have other active installment loans. If you don’t have a car, mortgage or other types of installment loan payments, it can disrupt your credit mix and may affect your overall credit score.

Before thinking to pay off your loan early you should think about your finances and what you have in your savings as well as how much emergency fund you’ve saved. You want at least 3 to 6 months of expenses saved in your emergency before you start paying down your debt. According to the credit bureaus any sort of negative affect to your score would be temporary.

RELATED: Paying Off a Loan Early – Does It Hurt Your Credit Score?

Is Paying Off a Loan Early Right for You?

You can start by using a loan calculator to determine how much you might save. Even if you have a prepayment penalty within your terms, it’s still worth checking the numbers to see whether it would work in your favour. The thing to do is run the numbers in each scenario you can think of to see if things look worthwhile. This would include if you were to put the extra money intended to pay off a loan towards other opportunities like saving or investing. Those with personal loans or car loans will sometimes consider paying off early to save one what might go towards interest charges. Checking your agreement and APR are ways of determining whether other fees may apply.

RELATED: Dealing with Credit Card Debt

As you get close to paying off your loan, the option of paying it off early will often cross people’s minds. The best way to know for sure if it’s the right move is to check for any prepayment penalties and run the numbers. Even with a penalty it can still make sense, so you would want to check how it works out using more than one scenario.