After comparing personal loan options and borrowing money from a recognized lender, you will begin paying back your loan principal plus interest in predetermined monthly installments. However, over the course of your loan period, it’s very possible that your financial situation could change and you are tempted to pay back a loan earlier than expected. There are certainly benefits of paying off a loan early, however, there could also be drawbacks.
Eliminating a major loan during good financial times makes sense for some. Perhaps you received a surprise lump sum of money from a holiday bonus, windfall inheritance, or after making a smart investment. You may think of taking that money to get yourself out of debt, and in many cases, that may be the right choice.
It may seem like a no-brainer to say that paying off a personal loan early would always make sense. However, you may be better off sticking to your usual monthly payments to build a better credit history. In addition, by paying off debt too early, you may miss out on other financial opportunities or wind up without enough emergency funds.
To help you determine whether or not to pay back your personal loan early, we’ve compiled a list of some pros and cons. Note that this is a partial list and, to fully understand the benefits and drawbacks of paying back your loan early, you should get in touch with the loan officer at the company you worked with.
Pros of Paying Off Your Loan Early
For some, paying off debt early represents the right decision. Living a debt-free life means no more monthly payments and can alleviate a lot of stress. Paying back debt also builds credit, making you more attractive to lenders if you need to borrow money in the future.
Peace of Mind
Eliminating a major financial obligation and having one less monthly payment on your hands can have a huge impact on your lifestyle and well-being. You no longer need to budget and make decisions with this personal loan in mind, and you can stop worrying about making monthly payments on time.
This advantage can’t be stressed enough. Figures suggest that the average person will pay $279,002 in interest on credit purchases over a lifetime. That’s like buying a house! This statistic assumes that you have good credit of at least 620. If you have poor credit, you could wind up paying a lot more than that on interest.
The takeaway? Paying off debt early means less interest payments in a lifetime. Developing those kinds of healthy financial habits could literally save you hundreds of thousands of dollars over time, not to mention, the stress relief you’ll benefit from becoming debt free and getting personal loan debt taken care of for good.
Paying out a loan early can, in some situations, result in savings realized from reduced interest payments. This is especially true with loans that have a higher APR, where the savings may be more significant. Note that this may not be the case with all lenders.
Improved Net Worth
Reducing your liability can improve your net worth making you look more favourable in the eyes of lenders. Lenders often calculate Debt service ratios to determine cash flow and one’s ability to service a loan. Paying off a loan may improve that debt ratio and your chances of being approved for other loans such as a business loan or a mortgage.
Improved Credit Score
Your credit score is affected by your credit utilization which is how much credit you have outstanding. A credit utilization that's too high may adversely affect your credit rating. Paying off a loan early reduces credit utilization and may indicate to your creditor that you can effectively manage debt and now have room to possibly take on more credit.
Cons of Paying Off Your Loan Early
It may seem counterintuitive, but actually having debt does have it’s benefits, so long as you make all your monthly payments in full and on-time. Paying off debt over time builds credit, which can qualify you for better rates on future loans or mortgages. In addition, you might get ahead of yourself, as paying off too much at once might cause you to fall behind on your budget. Continue reading to find out more about the reasons you might want to reconsider paying off personal loans early.
You might be better off investing your money
Many people fall under the misconception that all debt is inherently bad. But that might not be the case. Depending on the type of debt, you may be better off investing your money instead of using it to pay down low interest debts. Consider investments that could outperform any potential interest rate savings derived from paying off that debt early.
You could run into liquidity problems
Sure, maybe paying off your personal loan debt early will give you peace of mind in the short term. However, that requires paying a large chunk of money upfront. Aggressively paying off your debt and not keeping enough liquid funds can create cash flow problems, which can cause you to fall behind on your other bills or not having enough savings for unforeseen circumstances. In other words, to pay off debt, you may starve other funds.
You might miss out on the benefits of having debt
Debt is a very important component of building credit, especially for new or young borrowers. Hence using debt advantageously and making timely loan payments can be very instrumental in establishing your credit history.
Potential payout penalties
For some loans, there is an applicable early payout penalty. As such carefully review your loan documentation or discuss with your lender to see if it's worthwhile to payout loan early.
So how do you know if it’s a good idea to pay off the debt early? Consider a few of the following factors:
Do you have enough savings in case of emergency? You should always make sure to have an emergency fund to support yourself for at least three to six months in case. That way, when an unexpected expense happens, you will have enough to cover costs. If you don’t have an emergency fund, consider waiting to pay off that personal loan debt early until you’ve saved more money.
Would your money earn more in interest by investing? If you have enough money to pay off personal loan debt, you could potentially earn more money on interest by investing. Rather than paying off the debt at once, try to offset personal debt interest rates with investments that accrue even higher returns.
Do you have a strong credit history? Paying off a loan over time can help you build strong credit. New or young borrowers who lack credit history may fair better by building credit over time and waiting to pay off your loan early.
How much stress does the debt create in your life? For some people, having debt just isn’t worth the stress. In this case, you may prefer to pay off your loan early and avoid the hassle of monthly payments and interest.
Determining whether or not to pay off loans early also depends on the lender. Not all lenders and lending marketplaces offer the same rates and terms. So you’ll want to make sure to compare the options before taking out your loan.
Some of the best personal loan providers offer more flexibility, allowing you to pay back the money you owe without any payout penalties. Explore the best personal loans before making a decision to find out whether paying off your loan early makes sense in your financial situation.