Can You Pay Off A Personal Loan Early, And Should You?

Paying off a personal loan early can be a huge accomplishment that makes sense for many people, but it may not be the right choice for every borrower. Sometimes, paying off a loan early can even hurt your credit.

Let’s take a closer look at some factors to consider when you can pay off a personal loan early, and when you’d be better off directing your extra payments elsewhere.

Typically, lenders will allow you to pay off a personal loan early if you have enough money to make an extra payment or two. Paying a loan off early can save you in accrued interest, and you may even improve your credit score by lowering the amount of debt you owe.

Be aware, though, that certain factors – like prepayment penalties for the loan and higher-priority expenses and investments – could affect your ability to make extra payments on a loan. Additionally, paying off a loan completely can sometimes bring your credit score down.

Before deciding to put some extra cash toward your personal loan, first consider how paying the loan off early can affect you and your finances.

The Costs Of A Personal Loan

A personal loan works much like any other loan product:

1. You’ll borrow a set amount of money from a lender, who will provide you that money in a single lump sum.
2. You’ll pay the loan back over time in monthly installments.

This kind of loan comes with a cost, though, in the form of interest. By charging interest, the lender makes a profit on the money they’ve allowed you to borrow. Your interest rate is determined in large part by your credit score, typically 6% – 36% of your loan amount.

Generally, the higher your three-digit credit score, the lower your interest rate.

Paying off a personal loan early isn’t the right strategy for everyone, and both pros and cons come with choosing this option.

Here are some at-a-glance benefits and drawbacks to paying down your loan early.

Pros Of Paying Off A Personal Loan Early

Early repayment of a personal loan may temporarily hurt your credit, but it’s important to consider the long-term advantages of paying off a personal loan ahead of time. Below, we’ll discuss just a few.

You Can Save On Interest

If your interest rate or annual percentage rate (APR) is high, you’ll pay a lot more to borrow  money. That’s why paying off a personal loan early often makes financial sense – the sooner you pay it off, the less you’ll pay in interest.

Let’s say you get a personal loan for $5,000 with a 3-year term at an interest rate of 5.95%. If you take a full 3 years to pay off that loan, you’ll pay slightly more than $471 in interest. If you took that same loan and paid it off in 2 years, you’d pay about $315 in interest, saving yourself around $156 in the process.

The figures get higher, of course, if you borrow more money at a higher interest rate and for a longer term. Let’s say you take out a $10,000 personal loan at an interest rate of 7% with a 5-year repayment term. You’d pay about $1,880 in interest if you took the full 5 years to pay that loan back. If you instead paid that loan back in 3 years, you’d pay only about $1,115 in interest – a significant difference in savings.

You Can Lower Your DTI

Your debt-to-income ratio (DTI) is the amount of your income that goes toward your monthly debt payments. Paying off a personal loan early can lower that ratio, and having a lower DTI can make you eligible for a better interest rate on other loans.

You Can Increase Your Budget

A month-to-month budget plan can help ensure you have the money to afford all your monthly payments and day-to-day expenses. Freeing up the money that would normally go toward your personal loan can give your monthly savings or budget a boost. You could also put that extra money toward other debts, invest it or save for retirement.

Cons Of Paying Off A Personal Loan Early

Saving money on interest is a smart financial move, but this doesn’t mean that everyone who can pay off their personal loans early should do it. For some people, this isn’t the best decision. Consider the following reasons to hold onto your extra money rather than making extra payments on your personal loan.

You Have Other Debts To Consider

If you owe a significant amount on credit cards or other high-interest loans, it might make more sense to pay off those debts first.

A personal loan with an interest rate of 7% will cost you less than $4,000 worth of credit card debt at an interest rate of 20%, so it’s best to pay the more expensive debt off before worrying about your personal loans.

If you have a mortgage, auto loan, or both, be sure to always have enough money set aside for them, since missed payments on these loans can cost you your home and vehicle, respectively.

You Want To Build An Emergency Fund

If you don’t have an emergency fund, that’s another instance where it’s best to skip paying off your personal loan early. Instead, take your extra cash to build an emergency fund.

An emergency fund, as its name suggests, is a pool of money you only dip into to cover unexpected expenses. This way, you won’t have to accrue credit card debt paying for emergency medical bills or car repairs.

Most financial experts say you should have 3 – 6 months of daily living expenses saved in your emergency fund. If you don’t have this, building that fund might be better than paying off your personal loan.

You Could Invest The Extra Money

You might be able to make money by investing the dollars you’d spend on paying off your personal loan. Of course, this all depends on your loan’s interest rate.

You could invest your money in the stock market and earn a return percentage on your dollars. That might be a good move if your personal loan’s interest rate is lower than your potential return.

Paying a loan off early is one of several ways a personal loan can affect your credit.

When you finish paying off a personal loan, the account closes. Since your FICO® Score is heavily influenced by your credit history, closing the account can shorten the length of your history and, consequently, impact your credit score. Closing the account can also make your credit mix less diverse – another factor in your score.

How much or whether your score goes down can depend on your credit profile, but any drop should only be temporary as long as you’re still making on-time payments. With that in mind, weigh this potential effect on your credit report against the benefits that come with paying off a personal loan early.

Some lenders may charge a prepayment penalty to prevent you from taking out a loan and paying it back immediately. If, for example, you get a personal loan with a term of 5 years, your lender might charge a prepayment penalty if you pay off that loan in 3 years or less. Others might charge a prepayment penalty if you pay it off in any amount of time less than the full 5 years.

Prepayment penalties differ by lender. Let’s say you owe $2,000 on your personal loan and pay it off early. A lender might charge you 2% of your balance, or $40, as a prepayment penalty. Others might charge you a certain number of months’ interest. If you were paying $20 a month in interest, for example, a lender might charge you 6 months of interest, or $120, as a prepayment penalty.

Still, others might charge a flat fee if you pay off your loan early.

Avoiding Prepayment Penalties

Fortunately, it’s possible to avoid prepayment penalties. Try to work only with lenders that don’t charge them. Numerous personal loan lenders and lending platforms, including Rocket Loans℠, don’t levy prepayment penalties. If your lender does charge one of these penalties, decide whether the financial hit of the penalty will outweigh the savings in interest you could earn by paying your loan off early. If it does, paying your loan off ahead of schedule doesn’t make financial sense.

Will my credit drop if I pay off a loan?

Yes, your credit score can drop after closing a loan account, but only temporarily. Continuing to make monthly payments on other debts will bring your score back up over time.

Is it smart to pay off a car loan early?

Paying any loan off early can save you money in interest and free up funds you can put toward other expenses or savings. Some borrowers who can afford extra payments on a loan may instead put their money elsewhere. Every borrower has a different financial situation that can affect whether they decide to pay a loan off early. 

What kind of loan will not have a prepayment penalty?

Federal law prohibits lenders from issuing prepayment penalties on certain types of loans, including most government home loans and student loans. Rocket Loans doesn’t charge a prepayment penalty for personal loans.

If it’s possible to pay off a personal loan early, it might make financial sense to move in this direction. However, it may not be the best decision for you. Take a close look at your personal finances. Will paying off your loan work in your favor? That will depend on your loan’s interest rate, how much you owe in other debt and how prepared you are for a financial emergency.

Looking for a personal loan with no prepayment penalty? Start an application today with Rocket Loans.