If you’re making a payment on a personal loan every month, you might be itching to pay it off — especially if you’ve saved up enough money to wipe out that balance in one fell swoop. While paying off any loan early might sound like a great idea, there are several factors to consider before you whip out the checkbook.
Let’s start with the most basic point: before you dive into whether you should pay off a loan early, figure out if your loan is standard or precomputed. Precomputed loans have the interest included in the loan itself, so you don’t save anything by paying it off early. But if you have a standard loan – as most loan holders do – your interest is calculated daily. This means you can save money by paying it off early.
Why Paying Off Your Personal Loan Early Is a Good Idea
Interest savings is the most obvious reason you might want to pay back a personal loan before it’s due. Interest adds up, and all it really buys you is time to pay back the lender. If you have money in the bank that can wipe out that debt, you will save money on interest. Depending upon the size of your loan, this could range from hundreds to thousands of dollars.
Will paying off your personal loan early help your credit score?
Paying down your debts can improve your debt-to-income ratio. This is a ratio banks use to calculate how much of your income goes to paying off your debts. The fewer debts you have, the more likely a bank will see you as a good risk. That means you’re more likely to get a mortgage, car loan, or even another personal loan when you need it, with more advantageous terms.
Though it might seem that paying off a loan early would help your credit score, it really depends upon the terms of the loan and your overall financial health. If you’re trying to establish good credit, keeping the personal loan open and making payments on time can work wonders for that golden number. But if you already have an extensive credit history, including car loans or mortgages that were satisfactorily paid, any change in your credit score might be too small to matter.
The satisfaction of eliminating debt
Finally, there’s the mental and emotional satisfaction of wiping a debt from the books. It can be freeing to eliminate debt and watch your monthly bills drop, and can be enough to spur you to save even more money or invest more wisely.
Why You Might Want to Hold Off on Repaying Your Personal Loan
Though there are compelling reasons to pay off personal loans early, there might be other factors that mean that money is best directed elsewhere. That’s especially true if you have credit card debt with higher interest rates than what you’re paying on your personal loan. While personal loans might have interest rates in the 5-20% range, most credit card interest rates begin at the higher end of that spectrum, and might even exceed it. If that’s the case for you, it’s likely better to pay down those cards with the high interest rates first, then turn your attention to the personal loan.
Make sure you have an emergency cash reserve
Another point to consider is your emergency fund. Experts suggest an emergency fund that will cover your expenses for six to 12 months; if you don’t have that much in the bank, consider focusing on saving money for that rainy day before you embark on an early repayment of your personal loan. The last thing you want is to get into a financial bind and have to take out another personal loan to cover expenses.
Find out if you’ll be hit with a prepayment penalty
Consider any prepayment penalties. Some banks will charge a flat fee, or a percentage rate on the remainder of the loan if you choose to pay it off early. In some cases, the penalty will negate any interest savings you might have realized by paying the loan off early. In this case, it makes sense to continue making your regular payments and put that extra money toward something else.
How to Pay Off a Personal Loan Early
Have you decided that paying off your personal loan early is a good idea? Here’s how to do it.
- Get your facts in order. Read through the paperwork you signed when you got the loan. Look at the interest rate, early payment penalties, how much you still owe, and more.
- Do the calculations on how much you might save by paying it off early, even after paying any penalties.
- Contact your lender to ask about paying the loan early. Request a payoff statement that shows how much you will pay if you repay the loan on a certain date. Sometimes you can get this information directly from a tool on the bank’s website.
- Now that you know exactly what it will cost you, consider the cash you have on hand. Think about your emergency fund. Is the savings only marginal? It might be best to forgo the early repayment.
- If the savings are substantial, follow the lender’s instructions for paying off the loan. Some might require a wire transfer. Others might need a cashier’s check. If it’s not clear what your lender needs, contact them and ask.
- After you’ve made the final payment, request a statement that shows you paid the loan in full.
- Finally, check out your credit report a few months later to ensure everything looks good! You can do this for free.
Your financial life is made up of constantly moving parts. Take all of them into account when deciding if paying a personal loan off early is the right move for your financial future.