Paying your personal loan off early can offer some financial benefits. Depending on how your loan is structured, you could save a lot in interest costs, and freeing up the money you normally spend on the loan payment adds some cash back to your monthly budget.
But does paying off a loan early hurt your credit, and are there other downsides to doing so? Find out more about paying off a personal loan early below, including some tips for doing so while minimizing any potential disadvantages you might face.
Can You Pay Off a Personal Loan Early?
Yes, you’re allowed to pay off personal loans early. The better question is, “Should you pay off your personal loan early?” It’s important to weigh the pros and cons relevant to your specific situation before you pay off personal loans outside of the planned term.
To understand whether you should pay off a personal loan, first consider the general benefits and disadvantages that can apply.
|Potential Benefits of Paying Off a Personal Loan Early
|Potential Disadvantages of Paying Off a Personal Loan Early
|You might save interest.
You pay interest over the life of your loan, and paying down the principal of the loan faster than originally planned reduces how much you pay in interest. That’s because the interest is calculated on the principal amount, and if you pay some of that off early, the interest is calculated on a lesser amount. Depending on how your loan is structured and how fast you can pay it off, you might save hundreds or even thousands of dollars in interest payments.
|You might pay a penalty.
Some lenders build penalties into the loan structure that can lead to you paying fees if you try to pay the loan off early. They do this because if you pay the loan off early, you pay them less in interest. Interest is a primary way lenders make money, so some build other fees into the loan to ensure they get some money whether or not you pay off the loan early.
|You free up money for the month.
Paying off your personal loan early leaves more money in your pocket every month. If, for example, your monthly payments are $200, that’s $200 a month you can start saving. You may be able to earn interest on that savings, and starting as early as possible by paying off your loan to free up the money can mean more savings down the road.
|You might reduce your credit mix.
One aspect of your credit score is your credit mix. Creditors like to see that you can handle a healthy mix of installment and revolving debt. If your personal loan is your only installment account and you pay it off early, the lender closes the account. That means you won’t have an open installment account listed on your credit report, reducing your credit mix.
|You reduce your debt-to-income ratio.
Many lenders consider debt-to-income ratios when evaluating you for credit. This is especially true for larger loans such as mortgages or auto loans. Your debt-to-income ratio is how much in debt payments you have each month compared to your income. To get approved for a mortgage, your DTI must typically fall below a specific threshold, and paying off some of your debt early can help you get there.
|You may increase your credit utilization rate.
When your personal loan account is closed, that’s technically a line of credit removed from your credit report. This can increase your credit utilization rate, which might impact your credit score.
|You don’t have to worry about the loan.
Life gets busy, and every financial detail you must attend to can add to your personal workload. Sometimes, reducing the number of bills you need to pay each month can help you streamline your money management for better outcomes.
|You might drop your overall credit age.
Another factor that makes up your credit score is how long you’ve had credit and, on average, how long you’ve had your various accounts. If your personal loan is one of the older accounts you have and you pay it off, you can drop your overall credit age.
Whether or not you should pay off your personal loan early depends on how the considerations above relate to your current financial situation.
For example, if you’re just looking to save the interest cost, make sure you do some calculations. Start by figuring out exactly how much you might save. Then look at what it might cost to pay off the personal loan, including potential prepayment penalties and any impact to your credit. If you’re thinking about getting a new credit card or loan soon, will the potential hit to your credit result in a higher interest rate and more expense at that time? In this case, the disadvantages of paying off the personal loan early may outweigh the benefits.
On the other hand, if you’re preparing yourself to apply for a mortgage and need to lower your debt-to-income ratio, the benefits of paying off a personal loan early may outweigh the disadvantages. In the end, it’s a decision you must make for yourself after considering all the facts of your situation and loan.
5 Tips for Paying Off Your Personal Loan Early
If you decide that paying off your personal loan early makes sense for your situation, follow the steps below to increase your success in doing so.
1. Check for Prepayment Penalties on Your Personal Loan
Start by going through your loan paperwork to find out if there are any prepayment penalties. These are fees charged by lenders to help them recoup some of the money you would have paid in interest if you paid the loan off over the course of the entire term.
Note that not every personal loan has prepayment penalties. These fees must also be disclosed before you sign the loan and included in the written documentation about your loan. A lender can’t suddenly decide to charge these fees if you opt to pay off your loan and they haven’t previously disclosed them.
The existence of prepayment penalties doesn’t mean you shouldn’t pay off a loan early. However, it can change how much you have to pay to do so. You should also consider the total cost of those early payment penalties against the costs of paying your loan off over the entire term to understand which might be better for your finances in the long term.
2. Make Additional Payments Toward Your Principal
If you want to pay off a loan early and can drop the entire payoff amount in one go, that’s obviously the fastest way to go. But many people don’t have that kind of money to throw at a loan, so a more common way to pay off a loan early is to make extra payments on the principal balance.
You can do this by adding money to your loan payments or by making extra payments throughout the month. For example, if you’re supposed to pay $125 per month, you might pay $150 per month. The extra $25 can go toward paying down your principal faster. Alternatively, you might make two payments of $125 a month, with the second payment going entirely toward your principal balance.
When paying extra on a loan balance this way, it’s critical to pay attention to the details. Make sure it’s clear to your lender that you’re making extra payments on the principal of the loan. Otherwise, they may apply the extra payments toward your next month’s personal loan payment. While this helps you get ahead and pay the loan off faster, it may mean those extra payments are, in part, used to pay interest and not entirely put toward the principal balance.
Many lenders have options to ensure you can pay directly to the principal balance as long as you’re current with regular payments. If you mail a check to pay for your loan in response to a bill or with a ticket you tear out of a book, there’s usually an option on that piece of paper to indicate whether any extra you’re paying should go toward the principal. If you make your payments online and pay extra, most online payment processes ask if that extra should be applied toward your next payment or the principal of the loan.
Another important note is that if you do pay extra and ask for it to be applied to the principal balance, it does not count as getting ahead on your scheduled loan payments. You would still owe your next payment as agreed, and failing to make it could lead to late charges or other additional expenses.
3. Stick to a Budget
Paying off a personal loan early requires throwing more money at it than you might have planned. That might require finding some extra cash in your budget.
Look at your monthly expenses and compare that to your income to find extra money you can funnel toward your personal loan every month. You might do this by cutting out unnecessary expenses, such as eating out, or by increasing your income with a part-time job in the gig economy.
However you come up with the money to add extra payments to your loan every month, you only reach success if you stick with your plan. Track your income and expenses each month to ensure you’re sticking to the budget so you can pay off your loan early.
4. Refinance Your Personal Loan
In some cases, you might pay off your personal loan early without finding money in your budget. You do this by refinancing the loan, which means taking out a new loan to cover it.
Obviously, this tactic doesn’t leave you free of a personal loan payment. But it can reduce how much the loan costs you or how much you have to pay each month. That’s often the case when the original personal loan had extremely high interest rates or other poor terms. If you’ve improved your credit situation since you took out the first loan, you may be able to get a new loan with better rates and terms by refinancing, potentially saving yourself a lot of money in the long run.
5. Prepare for Loan Repayment With an Emergency Fund
Finally, avoid using your emergency fund or wiping out personal savings to pay off a personal loan early. While you might save yourself some money in the short term, what happens if an emergency comes up soon? You’re left without the cash to cover it, which could mean you have to turn to a high interest credit option. That can result in you spending more in the long run.
Will Paying Off Your Personal Loan Affect Your Credit Score?
Yes, paying off your personal loan early can have an effect on your credit score. Typically, the impact to your score is negative, in that your score might drop temporarily. That’s because, as noted in the table earlier in this article, paying off a loan early can result in:
- An increased credit utilization
- A lower credit age
- A less robust credit mix
It can be confusing because the opposite is actually true with a credit card. When you pay down a credit card balance, you decrease your credit utilization ratio. That’s because the account remains open, and you still have the line of credit associated with the card (as well as the credit age and mix).
The good news is that if you’re being responsible with your finances and actively working to improve your credit, any hit you take from paying off a personal loan early is likely to be temporary.
Responsible Lending From Wise Loan
Looking to refinance a personal loan or need a new loan after paying off an old one? Wise Loan can help. Wise Loan’s responsible lending services help you get the cash you need fast and build your credit while paying the loan back.
The recommendations contained in this article are designed for informational purposes only. Wise Loan does not guarantee the accuracy of the information provided in this article; is not responsible for any errors, omissions, or misrepresentations; and is not responsible for the consequences of any decisions or actions taken as a result of the information provided above.