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There are plenty of options where you can put your spare money, such as savings accounts, money market accounts, the stock market, and many others.
However, one possibility is to simply pay down the debt, such as personal loans. This might be useful for some people because they can save money on interest and reduce their liabilities.
Can I Pay Off a Personal Loan Early? How Does It Work?
Usually, banks allow their customers to pay off their personal loans early. However, if you decide to do this, there are a few things to consider:
- Prepayment penalties – If you decide to pay off your personal loan early, you have to pay prepayment penalties with some banks. So if you make a lump sum early repayment towards your loan, the prepayment penalty will be deducted.
This penalty is usually expressed as a percentage and varies depending on the institution. Some banks do not charge such penalties; for example, according to the Wells Fargo website, there are no early payment penalties.
- Interest and fees first – Even if the bank has no prepayment penalties, it is important to keep in mind that the funds replayed will be used to cover any outstanding interest payments and fees.
For example, if you make a $1,000 early repayment and owe $350 interest, the interest amount will be deducted, and only the remaining $650 will apply to the principle.
- No improvement on credit score – If you're looking to build credit with a loan, one thing to remember is that if you repay your loan early, it will not automatically improve your credit score. Yet, paying off your debt early will not harm your credit rating either.
In fact, according to Experian, one of the major credit bureaus in the US, it’s better to keep making payments on time rather than pay them off early if your main aim is to improve your credit score.
How Much You Can Save If You Pay Off a Personal Loan Early?
Let's take an example of a $20,000 loan for a term of 5 years with a 7% interest rate.
How Much You Save
As we can see, paying off your loan during the first 1-2 years significantly impacts the interest you'll pay. The earlier you pay it off, the more you save on interest.
Pros and Cons of Paying Off my Personal Loans Early
No doubt paying off your personal loan early does have some notable advantages. However, keep in mind the drawbacks and ensure it's the best step for your needs.
One of the most important advantages of paying off your loan early is that you can save considerable money on the interest.
For example, with low-interest personal loans, the interest rates range from 5% to 20% generally. Therefore, if you pay off early, you will no longer have to pay such high-interest rates on loans. This allows you to use this money for other purposes.
Besides purely financial benefits, paying off debt can also give you greater peace of mind.
You will have more disposable income and no longer have to worry about making payments on time.
You will improve your net worth by paying off your loan. The net worth is calculated by subtracting the value of your liabilities from your assets.
As your liabilities go down, your net worth will increase. This is an important benefit for those aiming to build wealth and create a large retirement fund.
The debt-to-income ratio, also known as the DTI ratio, represents the portion of your income used to make monthly debt payments. If you pay off your personal loan, this can certainly reduce your DTI ratio considerably.
This is important because you are more likely to be approved for personal loans and mortgages with a lower DTI ratio.
Payment history is the most significant component of the FICO credit score, accounting for 35%.
So if you pay off your loan early and close down the account, the payment history component will no longer improve and will have no positive impact on your credit score.
If you need to improve your credit score, it might be better to keep making payments according to schedule until they are paid in full.
Most major financial experts, such as Dave Ramsey, recommend having a sizable emergency fund for 3 to 6 months’ expenses. This is meant to allow you to keep up with your bills in case of layoff or other unexpected emergencies.
So if you deplete most of your cash reserves by paying off debt, this can be a risky financial step and can lead to some hardships going forward. On the other hand, paying off early will not have this drawback if you leave enough cash reserves on the account.
Saving money on interest can be beneficial. However, due to the interest rate increase in the recent year, there might be opportunities to invest for higher potential returns than the current interest rate on the loans.
So it is important to remember that opportunity costs are involved in decision-making.
When Might It Make Sense to Pay Off Your Personal Loan?
After discussing the advantages and drawbacks of paying off your personal loan, it seems clear that this decision will depend upon your circumstances. Indeed, there are several scenarios where such a decision might make much sense:
If you have a fully funded emergency fund and some extra funds to pay off your personal loan, this might not represent a significant financial risk. In this case, you will still have enough cash reserves to fall back on even after you pay off all the loans.
There is no universally accepted norm when the emergency fund is fully funded. However, most experts agree that you should have at least 3-month worth of expenses saved up.
Some personal loans are pretty expensive. For example, according to Citibank, the interest rates on personal loans range from around 10% to 24%.
Some other banks might have lower rates, but if you have to pay double-digit interest rates on loans, it might be better to pay them down since, in this case, the interest rate can add up to a considerable amount.
When It Might Not Make Sense to Pay Off Your Personal Loan?
At this stage, it is important to mention that in some cases paying off your personal loan might not make much sense:
If paying off your personal loan means you will have very few or no cash reserves left, this can be a significant financial mistake.
There is no guarantee that there will be no financial emergencies in the future. So this will expose you to severe financial risk and can even lead you deeper into debt. So it might be better to rebuild your reserves and only then consider paying off debts early.
Paying off a personal loan early might make little sense if you aim to improve your credit score. This decision will not harm the credit score.
However, it deprives you of the ability to benefit from improving your payment history, which is the most significant component of your credit score. So, in this case, it might be better to keep up with monthly payments according to the schedule.
Does Paying Off Your Personal Loan Early Make Sense For You?
There are five important questions you need to ask yourself before deciding whether or not paying off your personal loan early will be a worthy choice for you:
- Do I have enough cash reserves for emergencies after I pay off the loan early?
As discussed above, paying off debt makes little sense if it leaves you with very little savings to fall back on. So this is something to keep in mind before paying off your personal loan. On the other hand, if you have enough cash reserves, you do not have to worry about this problem.
- Have I already paid off other liabilities with higher interest rates than my personal loan?
If you have other types of debt with higher interest rates, such as credit card debt to pay off, it might be better to focus on those instead of paying off your personal loan.
- Do I already have a good credit score?
If you already have a good credit score and do not need to improve, paying off a personal loan might be a worthy choice. On the other hand, if you want to improve your payment history and FICO score, it might be better not to pay off this liability.
- Do I need to reduce my debt-to-income (DTI) ratio?
Paying off your personal loan might be a good decision if you want to qualify for a credit card or mortgage and bring down your DTI ratio. Generally speaking, most banks prefer giving credit cards to people with DTI ratios of 36% or lower
- Am I paying a high-interest rate on my current personal loan?
If you are paying a high double-digit interest rate on a personal loan, it might make sense to get rid of it as soon as it is financially viable. This can help you save a considerable amount on interest payments.
How to Pay off Your Personal Loan Early: Tips
If you have decided that paying off your personal loan early is the right thing for you, some tips might help you to achieve that:
- Regular extra payments – In most cases, you will not be able to come up with one lump-sum payment to pay off the loan entirely. Therefore, one alternative is to make a regular extra payment, such as monthly, weekly, or whatever frequency works for you best. In this way, you can reduce the principal much faster and save some money on the interest.
- Pay yourself first – This is a well-known principle in personal finance. The main idea is to save or invest money before spending your income. In this way, you can keep unnecessary expenditures to an appropriate minimum. On the other hand, if you wait until the end of the month to make an extra payment, you might have very little money left to do so after all the spending.
- Use Tax Refunds and Bonuses for Repayment – You can use tax refunds, bonuses at work, or inheritance to reduce your personal loan balance. This can go a long way towards achieving your goal.
Paying off your personal loan early will not immediately result in a reduction in your credit score. Yet, at the same time, it’s helpful to keep in mind that you need to maintain a regular payment history to improve your credit score.
So if you pay off your personal loan early but still make credit card payments, then this will have no negative impact on your credit score.
Paying off your personal loan does not directly improve your credit score. However, if you lower your debt-to-income ratio considerably, then this can certainly have a positive impact on your future loan or credit card applications.
You can pay off your loan anytime, provided you have sufficient funds to cover any outstanding interest payments, fees, and remaining principal.
The only consideration here is that some lenders might charge you higher pre-payment penalties if you pay off your loan during the first year of the loan issuance. However, there are also plenty of lenders who do not charge any prepayment penalties.
You can certainly pay off your personal loan faster by making regular extra payments on a weekly or monthly basis or with any other frequency which works for you.
At first, those repayments might seem like an insignificant sum, but over the long term, this can add up to a considerable amount.
Once you pay off your personal loan in full, you will no longer have to make monthly payments and pay any interest with this loan.
As a result, your debt-to-income ratio will also drop, making it easier for you to get approval for credit cards and other types of debt.