Paying Off a Loan Early: Should You or Shouldn’t You?
A personal loan is typically a small loan ranging from several hundred dollars to as much as $100,000. These are more likely to be unsecured loans. That is, the borrower wasn’t required to put down any collateral, but typically pays a higher interest rate to compensate for the risk the lender is taking.
People take out personal loans for all types of reasons, including to consolidate debt or make a purchase that is outside their current budget. These loans can be fixed rate or variable, secured or unsecured, and more than a few lenders will even give out loans to borrowers with poor credit.
If you do take out a personal loan, you may find that you have the ability to pay off the rest of the debt before the payment term is over. Whether or not you should pay off the debt early is an important consideration, and it’s worth taking a look at the pros and cons.
Advantages Of Paying Off A Loan Early
- Save money on interest
Personal loans tend to come with fairly high interest rates, especially if you have less than ideal credit or you’ve taken a longer-term loan. Interest builds up over the duration of a loan, so if you pay it back quicker you stand to save money on the interest, which could be a significant saving depending on the size of the prepayment fee. If you have the money to repay the loan early and the penalty is less than the savings, then it's a good idea to pay early.
- Goodbye monthly payment
Sure, you’d have to put a big chunk of change down, but wouldn’t it be nice to no longer have that monthly payment to worry about? Paying off a loan early does require saving up a good bit of money, but by ridding yourself of the monthly payment, you can better budget every month without worrying about another set payment right off the top.
Disadvantages of Early Payment
- Prepayment fees
Though it may sound counter-intuitive, some lenders charge a penalty fee for repaying a loan early, as a means of offsetting their loss of future interest payments. Look at it this way - the lending company provided a loan with a specific schedule and plan that both sides agreed upon, with expected economic rewards for the lender. However, by paying early, you stand to cost them some of the money they expected to make on the loan. These penalties are quite common with subprime mortgages, since these are often refinanced. One of the reasons people agree to a prepayment penalty is that often by agreeing to a penalty you can secure a lower interest rate on your loan.
The fee - often referred to as an exit fee or prepay fee - depends on the amount of the loan and is typically calculated by taking into account how much of the loan remains unpaid, the interest rate, and differences between your interest rate and current market rates if you have a variable interest loan.
- Your savings will take a hit
Though it's tempting to say goodbye to your monthly payments, it’s also smart to have a rainy day fund in the bank for when the need arises. By losing those extra funds you could potentially find yourself needing to take out another loan if you hit a rough patch.
- Lost investment opportunity
If you come into the money to pay off your debt in a lump sum, it could be wiser to take that money and invest it in a mutual fund or a similar portfolio that could earn you money in the long term. If the payments on your current loan are easy enough to make each month and the interest isn't too high, this could be a smart way to get your money to work for you.
What About Your Credit Score?
Though it's understandable that people would think paying off a loan early would help their credit score, the opposite is closer to the truth. Open accounts count more than closed accounts because they show that you are able to manage your credit and make payments in an orderly, regular fashion, and not just in a single large payment. By maintaining a higher credit score, you should be able to get loans in the future with more attractive interest rates.
Penalties for Paying Off a Loan Early
Often called a “prepay” in the lending industry, these penalties are a way for lenders to compensate for losing out on some of the interest, and can make it less appealing to pay off your loan early. Though they aren’t as common as they used to be, prepayment penalties are still a considerable expense to be taken into account before you sign on the dotted line.
An early repayment fee takes into account a number of factors, including how much is left on the loan. Many lenders set a fixed repayment fee, such as 6 months interest, or a flat fee of say, $500 if you repay your loan within the first few years.
A number of lenders go for a fixed percentage fee, such as 2% of the remaining loan. In such a case, if you had $10,000 left on a personal loan, then early repayment would include a fee of $200.
A good rule of thumb is that typically the fees will be higher the earlier in the loan term that you decide to prepay, because the lender is potentially missing out on a larger amount of interest.
Most top peer-to-peer lending companies like SoFi, LendingTree, and LendingClub say that there are no early repayment fees for borrowers, though with some of the other online financial institutions, it’s hard to determine the likelihood you will be forced to pay a fee.
That said, even if there is a prepayment fee, you could potentially save big money on the interest payments by paying ahead of time. It's up to you to read the fine print on any loan before deciding to sign, and to make sure that you can keep all your options open with the loan.
So, Is It Better to Pay Off a Loan Early?
There is something truly satisfying about the feeling of finally paying off a debt that has been hanging over your head - and paycheck - month after month. There is a feeling of accomplishment and the knowledge that you will no longer have to budget in the monthly payments on the loan.
That said, the process can cost you, and it is up to you to determine whether or not paying off your loan early will come with any additional fees that are large enough to offset any potential savings.
Take some time to shop around and see if you can find a lender who will provide a loan that has no penalty and still gives you an interest rate that won’t make the loan too expensive for you. If not, then consider your own needs in the years to come, and what you think is the likelihood that you’ll refinance or sell early. Sometimes the flexibility can be worth it, even with the penalty.
The bottom line: look closely at your loan conditions before signing, and if you do decide to pay early, make sure it will be worth it.