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So you’ve got a personal loan, and now you’re in a better spot financially. You might even have enough money to start paying off your personal loan early.
But before you start sending in those extra payments, there are a few things to think about first. While it’s always a good idea to pay down debt fast, there might be even better uses for that extra cash depending on your situation. And depending on your goals and how your loan is structured, there actually might be some benefit to keeping it for the full term.
Here are the main points to consider when deciding whether to pay off your personal loan early.
Can You Pay Off Personal Loans Early?
Yes, you can typically always pay off a personal loan early. However, that may come with a cost depending on your lender. While most personal loan lenders don’t charge you to pay off your loan early, some may charge a prepayment penalty if you pay off your loan ahead of schedule.
Prepayment penalties typically start out at around 2% of the outstanding balance if you repay your loan during the first year after applying and qualifying. Penalties then decline for each subsequent year of a loan until they reach zero.
If you’re thinking of paying off your loan early, check your loan documents or call your lender to make sure it doesn’t charge prepayment penalties before sending in some extra money.
When to Pay Off a Loan Early
If you have extra money, paying down your debt can help your finances, no matter what type of loan you have. However, it’s also true that your extra money could be more useful elsewhere, too.
Before you pay off a loan early, it’s a good idea to make sure that you have an emergency fund in place. That’s because if you send in your extra money and a disaster strikes, you might have to go into debt again, and you’ll be right back at square one. No one wants that.
If you do have an emergency fund in place, take a look at your other types of debt, especially their interest rates. Credit cards, for example, often have higher interest rates, so it can be a benefit to pay down that debt first with your extra money.
Finally, consider your long-term goals and what you could earn if you invested that money instead. If your personal loan charges a higher interest rate than what you could earn if you invested the money elsewhere, it’s usually a pretty safe bet to pay down your personal loan. But if you could earn more money in another investment, such as an index fund, it might be better to shuffle your cash there because you’ll earn more than you pay in interest on your personal loan.
Related: Personal Loan Calculator: Estimate Your Payments
Benefits of Paying Personal Loans Off Early
Paying off your personal loan has a lot of benefits, including:
- Saving money on interest
- Lowering your debt-to-income (DTI) ratio
- Eliminating the stress of owing money
- Paying off your debt and getting rid of your monthly payment sooner
Drawbacks of Paying Personal Loan Off Early
Here are some of the downsides of paying off your personal loan early:
- May reduce your opportunity to build credit
- Extra payments could have been used to save or invest
- You may have to pay a prepayment penalty
Does Paying Off a Loan Early Hurt Your Credit?
It seems kind of cruel—you’ve demonstrated good credit habits by not only paying off your loan on time but paying it off early. Shouldn’t you be rewarded with a better credit score?
Unfortunately, it’s not always so clear-cut. You typically won’t see that much of an impact on your credit score. Instead, a slightly bigger concern is that you won’t have as much opportunity to build credit. The more on-time payments you can get on your credit report (especially if you’ve made late payments before), the more it will help your credit score.
If you pay off the personal loan early, you lose the opportunity to make those on-time payments. (On the flip side, you also take away the possibility of making any late payments too, which would have an even bigger negative impact on your credit score.)
Also, once you pay off your personal loan, it’ll be marked as a closed account in good standing on your credit report, assuming all of your payments were made on time. If so, it’ll stay on your credit report for another 10 years. It will continue to help your credit score, but not as much as when it was an open account (i.e. if you were still paying it off).
If you pay off your personal loan three years early, for example, that means it’ll fall off your credit report three years sooner, and then it won’t help your credit score at all.
When it comes to paying off your personal loan early or not, it’s usually a matter of better and best. Both options are good, but one may be better than the other. If you’ve received some extra cash, paying off your personal loan will generally help you. But whether it’s the best use of your money is another consideration entirely.
If you’re the type of person who doesn’t like the idea of carrying debt and already has an emergency fund, you might do best with paying off your personal loan. On the other hand, if you’re more concerned with building credit and you think you can find a better use for that money elsewhere, then by all means choose to hang onto that debt a little longer by continuing to make the minimum payments.
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