The Pros and Cons of Paying Off a Personal Loan Early
Wondering if you can pay off a personal loan early? The good news is yes, usually you can. If you receive a cash windfall, using the money to clear debt ahead of schedule can save on interest. And your credit score may improve as you lower the amount of debt you’re carrying relative to your income. However, check the terms of your loan to see if it includes a prepayment penalty. And if you’re trying to build your credit history and the interest rate is not very high, consider putting that cash into a dedicated high-yield savings account and making those payments automatic to continue to build your credit history.
Let’s take a closer look at the advantages and disadvantages and what else you need to know if you’re thinking about paying off a personal loan early.
Pros of Paying Off a Personal Loan Early
Reducing debt and keeping it at a manageable level are important factors in achieving and maintaining good credit, as well as strengthening your financial situation. Paying off a personal loan early does all that and more.
1. Save money on interest.
The faster you can pay off a loan, the less it will cost you in interest. If you can pay off a personal loan early, it can lower your total cost of borrowing, potentially saving you a considerable amount of money.
For example, let’s say you’ve already repaid $10,000 on a $30,000 personal loan with an interest rate of 10% and three years left on your term. If you paid off the remaining $20,000 balance early in one lump sum, you’d save an estimated $6,000 in interest over the remaining term of the loan.
2. More money in your monthly budget.
If you can pay off your personal loan early, you’ll no longer have that monthly recurring payment hanging over your head, which means you can use those extra dollars in other ways. You could earmark that amount for daily expenses or apply it toward important financial goals like building an emergency fund or saving for retirement.
3. Lower your debt-to-income ratio.
Your debt-to-income ratio (the sum of your debts divided by your income) is a key metric lenders use to decide whether to extend credit. By lowering your debt-to-income ratio, it may have a positive impact on your credit score and help you qualify for more favorable loan terms and rates in the future.
4. Gain peace of mind.
The sooner you can pay off a personal loan the sooner you’ll be free of that debt.
One less financial obligation to worry about can reduce your monthly and weekly financial pressure. If you do pay off your personal loan early, make sure doing so won’t cause other financial burdens. For example, be sure you’re currently able to pay your other regular monthly bills on time and that you have at least three to six months of living expenses stashed in an emergency savings account. It’s best not to use the money in your emergency savings or retirement accounts to pay off a personal loan early as these accounts provide essential peace of mind and are there to support you in the future.
Cons of Paying Off a Personal Loan Early
While paying off a personal loan early can save on the cost of borrowing and trim your debt load, depending on your situation there are also some possible disadvantages.
1. You might get hit with a prepayment penalty.
Some lenders include a prepayment penalty clause in loan contracts to recoup the interest they would miss out on if the loan is repaid ahead of the scheduled loan maturity date. This amount is usually set as a percentage of the unpaid principal loan balance at the time of payoff.
Check your loan documents carefully and do the math before making your decision. Though you’ll save on interest, a prepayment penalty could partially or entirely wash away those savings, especially if your loan already has a low, fixed interest rate or a shorter term.
If you think you’ll be paying off a personal loan early before agreeing to the terms of any loan, try to find a lender that doesn’t charge a prepayment penalty. For example, LendingClub Bank doesn’t charge any prepayment fees or penalties, so you can pay off your loan early and reap the full benefits of any interest savings you may have earned.
2. It could impact your credit score.
It may seem counterintuitive, however, paying off a personal loan early could temporarily have a negative impact on your credit score.
For example, payment history is one of the biggest factors in determining your credit score and having a solid record of on-time, monthly payments can be beneficial for your finances in the long term. A personal loan appears on your credit report as an installment loan account, which includes the specific loan amount and repayment schedule. So, if you’re still in the process of building or repairing your credit scores, paying off a personal loan early means you could potentially lose out on months (or even years) of demonstrating a positive payment history.
The age of your credit accounts and whether you have a good mix of different types of credit can also affect your credit score. Considering these key measures, paying off a personal loan early may cause a temporary dip in your credit score. This is because when you pay off a personal loan, your lender will report the payoff and stop sending the credit agencies monthly updates about your account. If the loan was your only installment account, it could negatively impact your credit score because you might now have a less diverse mix of credit accounts. However, if you made on-time payments and your account was in good standing when you closed it, the drop in your score will only be temporary. On the other hand, if you missed payments, it may have a longer-lasting negative impact.
3. You may have better ways to allocate that money.
If the interest rate on your personal loan is lower than the rates you’re paying for other types of debt, the money you’ve earmarked for debt payoff may be better spent elsewhere. Instead of paying off your personal loan early, you could focus instead on paying off higher-interest debt first, such as credit card balances, which could save you more in the long run. You could also consider building up your retirement plan contribution at work to be eligible for an employer match or putting that money into a high-yield savings account.
And of course, before making changes to your monthly contributions or paying off a personal loan early, check your bank accounts and make sure you have the funds to cover both your anticipated monthly expenses and unexpected emergencies.
Does LendingClub Bank Charge Prepayment Penalties or Fees?
Personal loan rates, fees, and terms vary widely by lender. That’s why it’s always important to study the details of your offer so you don’t end up paying more than necessary, or more than you can reasonably afford given your budget.
At LendingClub, you can pay off your personal loan early or pay more than your contractual monthly amount at any time with no prepayment penalty or fee. Any payments you make on top of your regular monthly payment are applied toward reducing the principal balance of your loan. This flexibility allows you to reduce the amount of interest you’ll pay overall without worrying about hidden fees.
The Bottom Line
Whether to pay off your personal loan early depends a lot on the lender. Before deciding, consider all the potential fees and weigh the pros and cons to compare what you may gain in the short-term against your other financial goals. If you’re able to plan for paying off a personal loan early before taking out the loan, choose a lender who won’t penalize you for prepayment.
FAQs About Paying Off a Personal Loan Early
1. If I pay off a personal loan early, will I pay less interest?
Yes. By paying off your personal loans early you’re bringing an end to monthly payments, which means no more interest charges. Less interest equals money saved.
2. What is a prepayment penalty and why do they exist?
A prepayment penalty is a fee that some lenders charge when borrowers pay off all or part of a loan before the term of the loan agreement ends. Prepayment penalties discourage the borrower from paying off a loan ahead of schedule (which would otherwise cause the lender to earn less in interest income). The best way to avoid a prepayment penalty is to work with a lender that doesn’t charge one. At LendingClub, for example, you can make extra payments or pay off your personal loan in full at any time with no additional charges.
3. Will paying off my personal loan early affect my credit score?
It depends. Paying off your personal loan early can affect your credit mix, credit utilization, and credit history and, depending your personal financial situation, it may or may not affect your credit score. You may experience a temporary drop in your credit score if paying off your personal loan impacts any one of these credit scoring factors. Continuing to make payments on a lower interest rate installment loan (such as a personal loan) could help your credit score by boosting your history of on-time payments.*
*Reducing debt and maintaining low credit balances may contribute to an improvement in your credit score, but results are not guaranteed. Individual results vary based on multiple factors, including but not limited to payment history and credit utilization.