Can you pay off personal loans early?
When it makes sense and when you should wait
No one likes being in debt, so it's tempting to pay off a personal loan early if you find yourself with more cash than you expected. While it's always possible to pay off a loan early, there are a few factors that determine whether or not it makes sense.
If you're considering paying off a personal loan early, be sure you understand if you might be responsible for additional fees, and consider the potential for changes to your credit score.
5 things to consider before paying a loan off early
Here are a few things to think about before you pay off your personal loan.
1. Does the lender charge prepayment penalties?
While many personal loans don't have prepayment penalties, this fee is relatively common among lenders that serve subprime borrowers (those with lower credit scores). You can determine if your loan has prepayment penalties by contacting the lender directly and asking if the payoff amount includes any fees or penalties. You can also check your loan agreement.
Prepayment penalties start at about 2% of the outstanding balance on your loan. There may be additional rules as well. Some lenders charge the penalty only if you pay off your loan within the first year.
It's worth your time and effort to find out whether you face these fees and how much they are if you decide to pay off your loan early. The prepayment penalty should be less than the amount of interest you'd pay if you complete the full loan term.
2. How will paying off my personal loan early affect my credit score?
Reducing your personal loan balance to zero right away lowers your debt-to-income (DTI) ratio. If you're trying to qualify for a mortgage or another type of loan that requires a DTI under a certain percentage, paying off your personal loan could help.
However, if your personal loan is the only installment loan reporting your payment activity to the credit bureaus, eliminating the loan could negatively impact your mix of different credit types, which may cause your credit score to decrease slightly.
If you have more than one installment loan, your credit score may not take a hit if you pay off your personal loan early. An online credit score simulator like the FICO Score Estimator or the FICO Score Simulator, available through the Experian CreditWorks Premium subscription service, can help you anticipate how paying off your personal loan ahead of schedule may impact your credit score.
If you're trying to qualify for a mortgage, talk to your loan officer before you take any action that could impact your credit score.
3. What is the loan's annual percentage rate (APR)?
Your annual percentage rate (APR) is the cost of the loan in interest and other fees, expressed as a percentage of the loan amount per year. This figure helps you compare loans and decide which type of debt is costing you the most money.
For example: If your personal loan balance is $3,000, the loan has an APR of 14%, and your credit card balance is $3,000 with an APR of 34%, it makes sense to pay off your credit card before you pay off your personal loan.
Watch out for prepayment penalties, though. You may have a personal loan with a $3,000 balance and 21% APR along with a prepayment penalty of 2% of the outstanding loan balance, while your credit card debt has 20% APR. In this case, it may make more sense to pay off the credit card balance and make your loan payments as planned to avoid paying a $600 prepayment penalty.
If you are deciding between paying off credit card debt and paying off a personal loan, look closely at your loan terms and the APR of each of your debts before you act.
4. Will paying off your loan put you at risk?
You may save money on interest if you use your savings to pay off your personal loan, but doing so could impact your ability to cope with a financial emergency.
If you have at least three months' worth of living expenses set aside and can pay off your personal loan without touching that money, there's less of a chance that paying off your debt will put you at risk of financial harm if there's a financial crisis.
5. Does repaying your loan have clear benefits?
Before you decide to pay off your personal loan, figure out exactly how much money you'll save by doing so. If there isn't a clear benefit to eliminating the debt, it may be wise to pad your savings, pay off other high-interest debt or invest your extra money instead.
Pros and cons of paying off a personal loan early
Paying off your personal loan early may affect your credit score, so it's crucial to weigh the pros and cons before you reduce your outstanding balance to zero.
While you may save money on interest and eliminate the stress of owing money, you can also affect your ability to build good credit by making on-time payments. Plus, you may be subject to prepayment penalties if you pay off your loan early.
You are in the best position to evaluate the pros and cons as they apply to your financial situation. Here are a few points to consider as you decide whether to pay off your personal loan ahead of schedule.
- Save money on interest charges
- Lower your debt-to-income (DTI) ratio
- Reduce stress
- Eliminate a monthly payment from your budget
- Reduce your ability to build credit
- Could use money to pay off debts with higher interest
- Possible prepayment penalties
- Do personal loans have prepayment penalties?
Some personal loans have prepayment penalties, but many lenders do not impose this charge. A prepayment penalty is often a percentage of the outstanding loan balance. If your loan comes with prepayment penalties, you'll see them listed in the "Fees" section of your loan documents.
Prepayment penalties only apply if you pay off the loan ahead of schedule. Lenders charge these fees in an attempt to recapture some of the interest they lose when you pay off your loan early.
- Does paying off a personal loan early save money?
- Yes, if your loan doesn't include prepayment penalties, you'll save money on interest if you pay off your personal loan early.
- If I pay off a personal loan early, do I pay less in interest?
- Yes. Every month you eliminate from the payment schedule by sending extra money to be applied to the principal of the loan reduces the amount of time you'll make payments as well as the total amount of interest you'll pay over the life of the loan.
- How does paying off a loan early affect your credit score?
If you pay off your personal loan early, the lender reports that activity to the credit bureaus. The loan is considered "closed" on your credit report. The outstanding amount of the debt is eliminated from your total amount of debt, which reduces your debt-to-income (DTI) ratio. While this is good for your financial situation and may help you qualify for other loans more easily, it could be bad for your credit score.
Closed accounts and their corresponding activity don't weigh as heavily with the FICO credit score algorithm as open accounts, so all your on-time payments make less of a difference to your credit scores after the account is paid in full.
Closing an account could also reduce the mix of credit if you only had one personal or installment loan, which can lower your score. You'll also eliminate your chance to rack up on-time payments. Each month that you make a payment, your lender sends a report to the credit bureaus stating whether you made your payment on time or were late. On-time payments help you build good credit.
- How are personal loans different from other types of debt?
Personal loans provide a lump sum of money with a set repayment schedule. With a fixed-rate personal loan, your interest rate and monthly payments stay the same throughout the term of the loan.
With a credit card, you only pay interest on the amount of credit you use. Your credit card payments change from month to month depending on whether you carry a balance and how much you owe. Credit card interest rates may go up or down depending on market activity as well.
Some types of loans, including auto loans and mortgages, are secured with the vehicle or house you use the loan to buy; most personal loans are unsecured. Unsecured loans do not require you to put up something of value in exchange for loan funds.
For example, when you take out a title loan, a lender keeps the title to your vehicle until the loan is paid off. If you default on your payments, the lender can legally repossess the car and sell it to recoup its losses.
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