When you find yourself in financial distress, a personal loan can get you the money you need quickly. But these types of loans are not a panacea: they usually come with high interest rates. One way to reduce the cost of interest is to repay your loan early.
An accelerated withdrawal can have great advantages and serious disadvantages. A thorough understanding of your loan terms and financial situation can help you decide whether early repayment of a personal loan makes sense.
[Read: Best Personal Loans.]
Can you pay off a personal loan early?
You can usually pay off a personal loan early, regardless of who made it.
“I can’t think of a scenario in which you can’t pay off a personal loan early,” says credit expert Gerri Detweiler.
However, this does not mean that repaying a loan early is always a smart idea. For example, some personal loans have prepayment penalties. If you are paying off a personal loan early, you may have to owe a fee for the privilege.
Check to see if your lender is asking for a prepayment penalty.
“Most personal loans have no prepayment penalties,” says Detweiler. “If that’s the case with your loan, you’ll save money by paying it off faster.”
What are the benefits of early repayment of a personal loan?
The biggest benefit of accelerated loan payout is that it can save you money.
“In many cases the early repayment of a personal loan saves the borrower money in interest,” says Thomas Nitzsche, finance educator at Money Management International, a non-profit credit advisory agency.
With the loan payments out of the way, you have cash to replenish your monthly budget. You may have more money to serve another financial goal, such as investing, saving for a down payment, or just more “fun money,” says Nitzsche.
Borrowers with high debt-to-income ratios will find that early repayment of personal loans can decrease their credit, “potentially increasing their chances of being approved for another loan,” he says.
You can also expect emotional rewards. “Repaying a loan is a great emotional relief for many consumers, especially if the loan is related to a past trauma or a difficult or negative phase of life,” says Nitzsche.
You don’t have to worry about future payments, Detweiler adds, or what to do if your life circumstances change.
“If your income goes down or other expenses go up, you don’t have to worry about being able to make payments,” she says. “Being debt free or being closer to it can mean peace of mind.”
[Read: Best Debt Consolidation Loans.]
What are the disadvantages of early repayment of a personal loan?
There are several drawbacks to paying off personal loan debt early: You may have less cash available in the short term.
“If savings are used to repay the loan, this can lead to a shortage of the borrower’s emergency aid fund,” says Nitzsche. “Especially if the borrower is suffering from job insecurity, it may be best to keep the loan and keep making payments on time.”
In fact, in some situations, losing liquidity by investing money in a loan can be dangerous, agrees Detweiler.
“When you’ve invested every extra penny in debt, you may find that you haven’t saved money on unexpected expenses,” she says. “A financial emergency could mean that another loan has to be taken out.”
Another downside to putting extra money on a personal loan is that you could potentially get a better interest rate by investing the money instead, says Nitzsche.
Also, your personal loan may come with a prepayment penalty for early repayment of all or part of the loan. Check with your lender about this fee before proceeding to avoid any surprises.
How does early repayment on a personal loan affect your creditworthiness?
It may be tempting to pay off your loan early in hopes of improving your score, but that’s not how it works. The effects depend on what else is on your credit report.
“You can find that it drops a little, especially if you don’t have any other active installment loans – like a mortgage or a car loan – that report your credit reports,” says Detweiler.
Once you’ve paid off a personal loan, your credit report will show the loan complete. This is different from a credit card, which remains open even after the balance has been paid. FICO weights open accounts more heavily than closed accounts when calculating your score, meaning that repaying a personal loan is unlikely to help your credit score.
[Read: Best Debt Settlement Companies.]
Do’s and Don’ts on Early Repayment of Your Personal Loan
Before you repay a personal loan early, you should observe these rules of conduct.
Investigate your savings potential. “Use an online calculator to calculate how much you will save on various prepayments,” says Detweiler.
Make sure you have a Emergency fund. It should be enough to cover three to six months of living expenses before considering repaying your loan early. “In some cases it can make sense to pay off a little less aggressively in order to save up for an emergency,” says Detweiler.
Take a close look at the terms and fees. Determine if your lender charges a prepayment penalty and how that compares to the long-term interest cost of the loan.
Ignore other financial goals. Think about whether it makes more sense to pay off or pay off another line of credit, like a credit card or a car loan.
Overlook a payout schedule. If you decide to move forward, decide how fast you want to pay off the personal loan. Some borrowers may want to repay their loans quickly. “The savings you see can motivate you to find ways to free up extra cash to pay off the loan faster,” says Detweiler.
In contrast, others could benefit from a more gradual approach. “Placing the loan on Autopay with a rounded payment amount or making two-week payments – instead of monthly – are simple ways to repay the loan early,” says Nitzsche.
Neglect of balanceWishes and needs. “Create a plan to pay off your debts as quickly as possible without completely sacrificing your savings goals,” says Detweiler.