If you make loan payments on time and keep debt under control, good for you. Many people want to be in your shoes. Pat yourself on the back, but don’t wrench your shoulder doing it.
Imagine another scenario – paying off loans early. Does that sound like the impossible dream? It’s not.
Almost every type of loan can be paid off early, and there are many benefits for doing so. It can save you money. It can improve your credit score (though not always). It can provide peace of mind. It’s almost always the right thing to do.
Here’s what you need to know about paying loans early and how it can benefit you.
Saving Money on Interest
The best reason to pay off loans and other debts early is that it can save you money in interest payments. The only advantage of interest is that it allows you to pay more slowly and more manageably.
Interest doesn’t make the item you bought more valuable. The longer you pay, the more it costs. So, the quicker you pay off your loan, the less you ultimately spend on your purchase.
This is especially the case with credit cards or other high-interest debt. It’s a terrible idea to make only the minimum monthly payment. Paying off such debt is a sure way to save money. A good rule of thumb is the quicker you can pay for something, the less it ultimately will cost.
Let’s say you borrowed $25,000 for five years at 5% interest. If you pay on time for the full 60 months, you’ll pay $3,307 in interest. Paying it off early can eliminate some of that interest assuming you are paying simple interest, which most loans are.
A simple-interest loan has you pay interest based on what you owe at given time. The interest on that $25,000 loan would total only $2,635 if you paid it off in four years, a savings of $672.
However, if you have a precomputed interest loan, the amount of interest you pay is fixed regardless of when you pay it off. Some loans have prepayment penalties. Check the details before making a move.
Overall Better Financial Strength
Saving money may be the most obvious benefit to paying off loans early, but it’s not the only one. It can enhance your financial strength several ways.
Money that once went to monthly payments can be used elsewhere, such as paying off other debts, saving it or purchasing items you previously couldn’t afford.
It also makes you more likely to be approved for a new loan because it improves your debt-to-income ratio. That’s something lenders look at to make sure you can repay them, and money you’re spending on other loans is money you can’t spend on new ones.
Should you seek another loan, you may get a better rate because paying down debt can improve your credit score. One factor in credit scoring is how much you currently owe. Paying down debts increases how much you are capable of borrowing.
Personal Loans
Personal loans are popular because they can be used for any purpose and aren’t secured by any collateral. They come in handy when a large, unexpected expense leaves you without good alternatives.
However, their unsecured nature means they carry higher interest rates compared to home or auto loans.
Depending on the terms of the loan, not all personal loans can be paid back early. But, if they can, it’s a good idea. The same is true for credit cards, and for the same reasons.
The student loan debt crisis has received considerable attention because of the sheer size of it – roughly $1.5 trillion nationally. Those who owe large amounts would like to get out from under these debts, but it is wise to pay off loans with higher interest rates first. Paying off student loans should come after you’ve saved up an emergency fund of at least one month of basic expenses and begun contributing to a retirement account. Also, some student loans have tax advantages that go away if paid off early, so check into the tax implications first.
Mortgage Loan
Likely the biggest loan you’ll ever have is a mortgage loan, and the idea of burning that piece of paper is part of the American dream. But there are some things to check before trying to pay it off early.
First, check with your lender about any prepayment penalties. Obviously, interest is how lenders make money, so some mortgages include prepayment penalties to compensate for the revenue they will lose if it’s paid off early. Some lenders limit how much you can prepay toward your loan each year. You may be able to pay down the loan more rapidly without the penalty kicking in. Check to see if such penalties apply to your loan and whether the amount you save in interest would be more than the penalty.
If you decide to pay extra toward your mortgage each month, make sure the lender knows that the extra funds go toward your principal balance, not the interest. There may be tax implications to paying off your loan early, so check with your tax adviser.
As attractive as it is to pay off your mortgage early, only do so if you can comfortably afford it, which includes being able to keep money set aside for emergencies.
Car Loan
Just about every adult has had or will have a car loan. Whether to pay it off early is … complicated.
Paradoxical as it seems, paying off your car loan early can cause your credit score to drop a little because open accounts that are being paid on time have a greater impact on your score than closed accounts. Open accounts show how well you’re currently managing your credit rather than what happened in the past.
When should you pay off your loan early? If you have a high-interest or long-term loan (60-, 72- or even 84-month loans are offered), you’re going to pay a lot of interest. Before paying it off early, make sure there is no prepayment penalty or that you don’t have a precomputed interest loan. Also, if you’re looking to buy a home and need to improve your debt-to-income ratio, paying off your car loan could help you qualify for that mortgage.
When should you keep the loan? If you have a low-interest loan or 0% financing, there is little to no benefit to an early payoff. The same is true if you’re close to the end of the loan. If you don’t have an emergency fund, use your extra cash to start one before you pay off your car loan.
Should I Pay My Debt Off Early?
In most cases, paying off a loan early can save money, but check first to make sure prepayment penalties, precomputed interest or tax issues don’t neutralize this advantage.
Paying off credit cards and high-interest personal loans should come first. This will save money and will almost always improve your credit score.
Make sure you’re in a stable financial situation, which includes having an emergency fund.
If your credit score is your primary concern, paying off an installment loan early may not help you. An open, active account with a solid history of on-time payments shows credit bureaus that you are a responsible borrower.
If you need help evaluating which debts to pay down first or have more questions consider credit counseling.
