If you’re struggling to make loan payments, the thought of being debt-free can sound like heaven. If you can pay off your loan early you’re one step closer to a debt free life. Some financial experts tell you it’s possible with hard work and grit. The way to do it, they explain, is to tackle your debt like an animal and devote every spare dollar to paying off your debts ahead of schedule.
That sounds like brilliant advice, and in some circumstances it is. There are also times when you might not want to pay off a debt ahead of schedule. You’ll have to study your situation and consider the pros and cons of paying a debt off early.
- Reduced amount of interest
- Extra money in your budget
- Lower debt-to-income ratio
- Lower insurance costs
- Prepayment penalties
- Impact on your credit score
- Miss out on an opportunity to pay off debt
The Advantages of Paying Off a Loan Early
There are some important advantages to paying off loans early, which is why so many people encourage it. Let’s look at some of them.
Think of Mel Gibson’s cry at the end of Braveheart. If you’ve been enslaved by debt for 3, 4, 5 or 30 years paying your loans off ahead of schedule can bring an overwhelming sense of relief. There is a difference between going to work because you want to and going to work because you have to. When you pay off your loans early, that monkey on your back is gone and so is the weight of the monthly obligation you have been carrying around. That’s a very good reason to attack your debt.
✅ Reduced Amount of Interest Paid
When you take out a loan, you are agreeing to pay back the amount with interest. In most cases the longer it takes to pay off the loan, the more interest you’ll pay. If you pay off a loan early you will usually end up paying less interest than if you had paid the loan in the scheduled amount of time.
Use the early payoff calculator below to see just how much you would save on interest by paying off your loan early:
➗ Go to the full page to view and use the calculator.
✅ Free Up Your Budget
When you take out a loan the lender has the right to claim a percentage of your monthly income until the loan is paid. That means you have to set aside that amount for the loan payment, month-in and month-out.
If you pay off your loan early you no longer have to allocate that sum to debt payment. Instead, it becomes discretionary income. You can apply it to paying off another debt, add it to your savings or retirement funds, or use it to reinforce a part of your budget that’s been under stress. That gives you options you didn’t have before.
✅ Lower Your Debt-to-Income Ratio
Your debt to income or DTI ratio is the percentage of your monthly earnings that you spend on debt payments. Your DTI ratio is one of the criteria that lenders use to determine your eligibility for credit. It’s especially important if you’re applying for a mortgage. Most mortgage lenders prefer a DTI ratio under 36%, and many will not lend at all if your DTI ratio is over 43%. A high DTI ratio can mean higher interest rates or even place loans out of reach.
Paying off debts early can reduce your DTI, which can be an important goal, especially if you’re considering applying for a mortgage.
➗ You can use our Debt-to-income Ratio Calculator to determine your DTI.
✅ Lower Insurance Costs
When you take out a car loan the lender retains an ownership interest in your vehicle until the loan is paid. Lenders want to protect that interest, so they typically require full insurance coverage. Once you pay your loan and own your car free and clear, you can decide how much coverage you need. If you choose to reduce your insurance, your cost will probably decrease. Remember not to cut your coverage too much. You could face serious costs in the event of an at-fault accident. Discuss your coverage with a qualified insurance agent and determine what you need.
The Disadvantages of Paying Off a Loan Early
There are significant advantages to paying off loans early, but some people might encounter disadvantages as well. These factors might be less obvious to most people. We all know that being in debt is bad, so getting out of debt early seems like it must be good. Before we leap to that assumption, let’s look at what can go wrong.
❌ Prepayment Penalties
Paying a loan off early usually means a lower total interest payment on the loan. That’s a good thing for you, but it’s not a good thing for your lender, who relies on those interest payments income. Some lenders impose prepayment penalties to assure that they get the expected profit on their investment. Prepayment penalties are often used in car loans.
Before you decide to pay a loan off early you should check the loan terms for a prepayment penalty. The penalty will usually be a percentage of the outstanding balance. The prepayment penalty may eliminate any advantage you’d get from reducing your total interest cost on the loan. Think carefully and calculate your costs and benefits before choosing to pay a prepayment penalty. You might be better off paying the loan on schedule.
❌ Impact On Your Credit Score
You’d think that paying a loan off early would help your credit, but that’s not always the case. Credit scoring models consider a number of factors, including your credit mix, the length of your credit history, and the number of open accounts you have. They also give active accounts more weight than closed accounts.
Creditors like to see a mix of revolving credit (like credit cards) and installment credit (like a car loan or student loan). If you have only a few installment loans in your credit history paying them off early could adversely affect your credit mix. Paying off an older loan (like a student loan) early could reduce the average age of your open accounts and your number of open accounts. It sounds strange, but an active account in good standing can often do more for your credit than a paid off account.
Paying off a loan early could dent your credit, but the impact is likely to be small and it generally won’t last long. You’ll only need to be concerned if you have a thin credit file with a short history and few accounts. If you have an extensive credit history with multiple accounts you probably won’t even notice the impact.
Even if the impact is small, it could make a difference, especially if you’re considering applying for credit and a small drop in your score could raise your borrowing costs or even leave you ineligible.
Check Your Other Financial Goals
If you’re thinking about paying off loans early, consider the other things you could do with that money. The money you use to pay off your loan cannot be used for anything else, and that could mean missing an important opportunity.
Do you have an emergency fund? A good rule of thumb is three to six months in savings to cover an emergency. Do you at least have enough to cover a $1,000 emergency?
⚠️ If your emergency fund is limited or you don’t have one, the money you’d use to pay off a loan early might be better used to start one or build one up.
If you have a 401(k) or IRA, an extra contribution to your retirement account could be a better use of funds than paying off a loan early. That’s especially true if your employer will match a portion of your 401(k) contribution!
⚠️ The return on your investment could be greater than the interest you’d save by paying a loan off early.
This is an important consideration if you’re considering paying a relatively low interest loan, like a mortgage. Your investment earnings should exceed the interest rate you’re paying on the mortgage. That will usually make investment a better choice.
If you do decide to pay loans off early, be sure to focus on the right loans. You may be desperate to get that old student loan off your back, but look at other debts first. If you’re paying 5% annual interest on the student loan and 20% on a credit card balance, prioritize that high-interest balance.
☝️ Keep emotion out of the picture and focus on your most expensive debts!
Should You Pay Off Your Loan Early?
There are many factors to consider when deciding whether to pay off your loans early. It might be a good idea and it might not be. The choice will depend on your personal goals, your financial situation, and the terms of your loans.
Before making a decision you’ll need to assess those factors and make sure paying a loan off early is the right choice. Freedom from debt may be just what your heart needs to soar, but you’ll want to make sure your wallet agrees with your heart!