Yes, you can pay off a personal loan early. But it is not always advisable to do so. There are both risks and benefits to an early payoff.
You’ll need to consider several factors when making a decision, such as the type of loan you took out. Emergency loans, no-credit-check installment loans, and no-income loans come at much higher interest rates. In their case, an early payoff is generally a good idea.
It is also important to keep in mind other payments you need to make, such as utilities, savings, or tuition payments for your children. Paying a loan ahead of schedule should never come at the cost of your other financial obligations. Make sure to cover all your financial bases before making a decision.
Table of Contents
- 1 What Happens if I Pay Off My Personal Loan Early?
- 2 What to Ask Yourself Before Deciding
- 3 Should I Pay Off My Personal Loan Early?
What Happens if I Pay Off My Personal Loan Early?
Paying off a personal loan early comes with advantages and disadvantages. While you may end up paying less in interest or receive freedom from debt, you might also be subject to prepayment penalties or see a temporary drop in credit score.
If your loan carries high interest rates, you’re interested in consolidating your debt, or it’s your very last loan to pay off, the disadvantages may be worth paying ahead of schedule. Unfortunately, an early payoff is not that simple and each person must navigate the situation with their finances in mind.
Advantages of an early payoff include:
- Reduced interest: An early payoff means you’ll pay less in interest. This is especially beneficial for loans with high interest rates.
- More freedom from debt: Nobody wants to be in debt. An early payoff is a great way to gain more freedom from debt.
- Eliminate the risk of late or missed payments: An early payoff eliminates the risk of being late or missing a payment on a debt — which inevitably lowers your credit score.
Drawbacks of an early payoff include:
- Prepayment penalties: An early payoff can trigger prepayment penalties. These are fees that lenders charge if you pay off all or a part of your loan early.
- Neglecting other payments: An early payoff may come at the cost of saving for retirement, making investments, or putting children through college. Be careful not to pay off a loan at the expense of another important financial goal.
- Temporary drop in credit score: An early payoff can negatively impact your credit score. If the personal loan was your only installment account or your only low-balance account, your credit score will likely take a temporary dip.
Will Paying Off a Personal Loan Early Improve My Credit Score?
Paying off a personal loan early is generally good for your credit score. But it’s not the same as paying off a credit card. When you make a large payment to your credit card, you reduce your credit utilization. This is what gives your score a slight rise.
Personal loans differ in that they show up on your reports as a closed account. The issue here is that FICO weighs open accounts more heavily than they do closed accounts. Open accounts reflect how well you are managing your debt. While closed accounts are still beneficial to your score, they don’t have the same impact as open accounts.
Moreover, taking out a personal loan improves your credit mix — another aspect of your credit utilization ratio. Once you pay off the loan and close the account, you reverse this process. With less credit diversity, your score may take a dip.
What to Ask Yourself Before Deciding
Below is a series of questions to ask yourself before paying off a loan ahead of schedule:
How Soon Do You Need a Good Credit Score?
Paying off a personal loan early won’t catastrophically affect your credit score, but it will temporarily damage it. If you need a good score soon — such as to take out a mortgage — it may be best not to pay off your loan ahead of schedule.
How Much Will You Save by Paying Off a Personal Loan Early?
It may come as a no-brainer that you don’t want to pay off a personal loan early, if you won’t be saving any money. Perform the following calculation to see how much you’ll be saving.
Using a personal loan payment calculator: take your current loan amount, interest rate, and remaining loan term to find the total amount of interest you’ll have to pay. Next, alternate decreasing your remaining loan term and increasing your monthly payments. This calculation shows you how much sooner you’ll pay off your debt and what you’ll save on interest.
Does Your Loan Come With Prepayment Penalties?
The previous calculation does not take into account prepayment penalties. Always contact your lender before paying off a personal loan, in case there is a prepayment penalty.
You may be able to negotiate the loan terms with them — and they may even remove the penalty. If they don’t, you’ll want to compare the prepayment fee to what you would have owed on interest.
Should I Pay Off My Personal Loan Early?
With savings in mind, consider whether paying your loan off early has significant and noticeable benefits. If you’ve done the math and found that it will save you thousands of dollars, allow you to take out a mortgage, or otherwise help your financial situation then paying off your loan early may be recommendable.
Every situation is unique and while paying off a loan early may hurt one person, it may considerably help another. Whatever your reasons, make sure to weigh the benefits with the risks of an early payoff. This is the only way to assess whether the decision will be beneficial.
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