When Does Paying Off a Personal Loan Early Make Sense ?

·5 min read

When you are in a financial jam, a personal loan can provide you with the quick cash you need. But these types of loans are not a cure-all: They typically carry high interest rates. One way to cut interest costs is to pay off your loan early.

An accelerated payoff can come with major benefits and serious drawbacks. A thorough understanding of your loan terms and your financial circumstances can help you decide whether paying off a personal loan ahead of schedule makes sense.

[Read: Best Personal Loans.]

Can You Pay Off a Personal Loan Early?

Typically, you can pay off a personal loan early no matter who issued it.

"I can't think of a scenario I've seen where you can't pay off a personal loan early," says credit expert Gerri Detweiler.

But this does not mean that paying off a loan early is always a wise idea. For example, some personal loans have prepayment penalties. If you pay off a personal loan early, you might owe a fee for the privilege of doing so.

Check whether your lender charges a prepayment penalty.

"Most personal loans don't carry a prepayment penalty," Detweiler says. "If that's the case with your loan, you'll save money by paying it off faster."

What Are the Pros of Paying Off a Personal Loan Early?

The biggest advantage of speeding up loan payoff is that it can save you money.

"In many cases, paying off a personal loan early will save the borrower money in interest," says Thomas Nitzsche, financial educator at Money Management International, a nonprofit credit counseling agency.

With loan payments out of the way, you free up money to pad your monthly budget. You may have more funds to direct to another financial goal, such as investing, saving for a down payment or just having more "fun money," Nitzsche says.

Borrowers with high debt-to-income ratios will find that paying off personal loans early can reduce theirs, "possibly increasing their chances of being approved for another loan," he says.

You can also expect emotional rewards. "Paying off a loan is a huge emotional relief for many consumers, particularly if the loan was related to past trauma or associated with a difficult or negative period in their life," Nitzsche says.

You will not have to stress over future payments, Detweiler adds, or what to do if your life circumstances change.

"If your income goes down or other expenses go up, you won't have to worry about whether you can cover the payments," she says. "Being debt-free, or closer to it, can mean peace of mind."

[Read: Best Debt Consolidation Loans.]

What Are the Cons of Paying Off a Personal Loan Early?

Paying off personal loan debt early has a few downsides: Namely, you may have less cash on hand in the short term.

"If savings are used to pay off the loan, it may create a shortage in the borrower's emergency use fund," Nitzsche says. "Especially if the borrower is experiencing job uncertainty, it may be best to keep the loan and continue making on-time payments."

Indeed, losing liquidity by putting money toward a loan can be dangerous in some situations, Detweiler agrees.

"If you've put every extra penny toward debt, you may find you haven't saved money for unexpected expenses," she says. "A financial emergency could result in having to take out another loan."

Another drawback of putting extra money toward a personal loan is that you may be able to earn a better rate by investing the funds instead, Nitzsche says.

Also, your personal loan may come with a prepayment penalty for paying off all or part of the loan ahead of schedule. Ask your lender about this fee before you proceed to avoid surprises.

How Does Paying Off a Personal Loan Early Affect Your Credit?

It might be tempting to pay off your loan early in hopes of boosting your score, but that is not how it works. The impact depends on what else is in your credit report.

"You may find it drops a little, especially if you don't have other active installment loans -- such as a mortgage or car loan -- reporting to your credit reports," Detweiler says.

Once you pay off a personal loan, your credit report will show the loan as closed. That differs from a credit card, which remains open even after you pay off a balance. FICO weighs open accounts more heavily than closed accounts when calculating your score, which means paying off a personal loan is unlikely to help your credit score.

[Read: Best Debt Settlement Companies.]

Do's and Don'ts of Paying Off Your Personal Loan Early

Before repaying a personal loan early, keep in mind these do's and don'ts.

Do:

Investigate your potential savings. "Use an online calculator to understand how much you'll save with various prepayments," Detweiler says.

Make sure you have an emergency fund. It should be enough to cover three to six months of living expenses before you think about paying down your loan early. "In some cases, it may make sense to pay it off a little less aggressively in order to make sure you're still saving for emergencies," Detweiler says.

Look closely at terms and fees. Determine whether your lender charges a prepayment penalty and how it compares with the loan's long-term interest costs.

Don't:

Ignore other financial goals. Consider whether paying off or paying down another line of credit, such as a credit card or auto loan, makes more sense.

Overlook a payoff plan. If you decide to forge ahead, determine how quickly you want to pay off the personal loan. Some borrowers may want to pay down their loans fast. "The savings you see may motivate you to find ways to free up extra cash to pay off the loan faster," Detweiler says.

By contrast, others might benefit from a more gradual approach. "Putting the loan on autopay at a rounded-up payment amount or making biweekly payments when you get paid -- instead of monthly -- are easy ways to pay down the loan early," Nitzsche says.

Neglect to balancewants and needs. "Create a plan to pay down your debt as quickly as you can without completely sacrificing your savings goals," Detweiler says.

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