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If you have personal loan debt and are in a financial position to pay it off early, doing so could save you money on interest and boost your credit score. That said, you should only pay off a loan early if you can do so without tilting your budget, and if your lender doesn’t charge a prepayment penalty.
It is wise to have at least three to six months’ worth of expenses saved up before you worry about paying off a loan early. As long as you are making your minimum monthly payments, your credit will not suffer. If you decide that paying off your loan early is right for you, there are several steps you need to take to ensure it goes smoothly.
- Paying off your loan early can save you hundreds — if not thousands — of dollars worth of interest over the life of the loan.
- Some lenders may charge a prepayment penalty of up to 2% of the loan's outstanding balance if you decide to pay off your loan ahead of schedule. Additionally, paying off your loan early will strip you of some of the credit benefits that come with making on-time monthly payments.
- Making additional payments and refinancing your loan are some of the options you can explore to pay off your loan ahead of time.
- The average personal loan has an interest rate of 10.82% – that’s 47% less than the average credit card interest rate, which sits at 20.60%.
- The average personal loan balance in the U.S. is $10,334.
- The Dodd-Frank Act caps prepayment penalties for personal loans at 2% of the outstanding balance during the first two years of repayment. For loans that have reached their third year or over, this penalty is capped at 1% of the outstanding balance.
- If you have a $10,334 36-month personal loan and decide to pay it off early, that means the lender could charge you a prepayment penalty of up to $207.
- Paying off your loan early could save you hundreds — if not thousands — of dollars down the road. For instance, paying off the $10,334 personal loan in 18 months instead of 36, would result in $700 in savings, even if a 2% prepayment penalty is assessed.
Paying off a personal loan early comes with both benefits and drawbacks. On the one hand, you save money on accruing interest when you pay off a debt early, and your debt-to-income ratio will go down.
However, some lenders charge a prepayment penalty for early payments, and using your spare income to pay off your loan early means it won’t be available for other expenses. Plus, making on-time monthly minimum payments boosts your credit score, and you’ll miss out on that opportunity if you pay the whole thing off early.
If you aren’t sure if the drawbacks outweigh the benefits, you can use Bankrate’s loan calculator to help you make a decision. However, if you decide that paying off your loan early is the best option, here are five key steps you should take:
Break down payments
As long as your lender does not charge any prepayment penalties, you can break down your monthly loan payment into two biweekly payments. This is the easiest way to work down your debt faster.
By breaking down your payments this way, you will be making one additional payment per year, thus speeding up the payoff process. This method allows you to reduce your total interest paid and shorten the overall life of the loan by splitting your monthly payment into two chunks and paying a little more on each.
If your monthly minimum loan payment is $400, you could make payments of $225 each month and pay an extra $50 a month toward your principal balance. This allows you to stay ahead and pay off your loan earlier while still getting the credit benefits of making regular payments.
Breaking down your loan payments into smaller biweekly payments could be a good option if you receive biweekly paychecks and want to chip away at your debt more quickly without exhausting your funds. However, speak to your lender before making this change, as some lenders may have stricter repayment plans or may charge prepayment penalties.
Make extra payments when you can
If you don’t have enough extra income to make higher payments every month, you can still make extra payments from time to time to work down your debt.
Consider using extra income from holidays, birthdays, bonuses and other extra savings throughout the year. It can even be as simple as skipping eating out once a month so you have a little extra money in the budget for your loan payment. This method is just about changing up your habits slightly to make room in your budget for extra loan payments.
That said, this should only be done if you have enough money saved. According to a Bankrate survey, only 43 percent of U.S. adults would be able to cover a $1,000 emergency expense using their savings. If that’s your case, focusing on making the monthly minimum may be the best thing you can do. This will keep your credit score in good standing, while you work on growing your nest egg.
But if you do have enough saved and want to put any extras toward paying off your personal loan, making a principal only payment can be a good idea. When you make a principal only payment, you’re essentially saving more on interest each month by reducing your outstanding balance. You can make this type of payment by contacting your lender and specifying that you’d like the additional payment to go toward the principal balance.
Consider adding a secondary stream of income
If you have the time, finding extra income could be a good way to save up to pay off your loan early. Getting a side hustle doesn’t have to mean getting a second job. There are a variety of ways to make a little extra money. You could try babysitting, pet sitting, tutoring, food and grocery delivery, opening an Etsy shop, driving for Uber and countless other endeavors.
Having a side hustle has become increasingly popular, with 40 percent of Millenials reporting their side hustle makes up at least half of their income. However, a Bankrate survey found that 41 percent of people with a side hustle do so to cover everyday living expenses. Only 17 percent of people with side hustles put that extra income toward savings, and only 12 percent use the funds to pay down debts.
If you are considering starting a side hustle to pay down your debts, make sure you allocate funds to everyday expenses and savings before worrying about paying off your debt.
Revisit your budget
Building and maintaining a monthly budget is a great way to organize your finances and see where you have opportunities to save. However, it can be difficult to maintain a budget, especially as inflation continues to be high and many are struggling to make ends meet. Only 32 percent of U.S. households prepare monthly budgets.
Making a monthly budget allows you to track your spending habits and determine where you could cut back and save. For example, a recent survey found that 42 percent of respondents were paying for subscription services they no longer used. If you are looking to allocate more funds toward repaying your loans, reorganizing your budget and looking for places to make cuts could be a great way to do that.
If you are new to budgeting, Bankrate has resources available to help you get started. It could also be worth speaking with a financial advisor if your situation is more complicated or if you need more specialized advice.
Look into refinancing your personal loan
Refinancing allows you to transfer your current debt to a new loan with a lower interest rate or a different repayment plan. Refinancing your loan can lower monthly payments and get you out of debt faster.
However, refinancing a loan is not right for every circumstance. You should only refinance your loan if you can secure a lower interest rate on the new loan or if you need to extend your repayment term. If your credit score has increased recently and you think you may qualify for lower interest rates with the new score, refinancing could help you secure that lower rate.
Refinancing your loan and securing a lower interest rate will lower your monthly payments, allowing you to pay off the loan more quickly. It also gives you the chance to choose a shorter repayment period, which will shorten the life of your loan overall.
However, review the terms of your lender before deciding to refinance. If you are almost done paying off your loan, or if the interest rate on a refinanced loan would be higher, this process is likely not worth it. Pay attention to fees you would have to pay.
Here’s a breakdown of how term lengths affect your interest rate:
As shown above, the shorter your repayment period, the better the chances of securing a lower interest rate. That’s something to consider when refinancing your loan.
Frequently asked questions
You can pay off a personal loan early, but you should only do so if you can comfortably afford it. You should also make sure that your lender does not charge a prepayment penalty for paying the loan off early.
Paying off loans early could negatively impact your credit by minimizing your credit mix, payment history and credit utilization. However, if you have a healthy credit mix outside of the loan you want to pay off early, this effect will be temporary. Your credit will not suffer long term.If you have little credit history, it may be worth keeping the loan. If you have a solid mix, the benefits of paying off the loan early outweigh this risk.
You can reduce your total loan cost by paying more than the minimum each month or refinancing your loan with a lower interest rate.
The amount of time it takes to pay off a loan depends on your personal financial profile and the repayment terms offered by your lender. Lenders typically have set repayment periods available. The one you are eligible for depends on your financial situation and the amount of money you borrow. You can pay your loan off faster if your lender does not charge any prepayment penalties.