Paying off debt early: Advantages and disadvantages
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As of the second quarter of 2022, the amount of consumer debt in the United States totaled over $16 trillion. Many Americans face extreme financial hardships, regardless of age, education and income level due to overwhelming debt. Whether you’re buried under student loans, credit card fees or a mortgage you can’t afford, debt can land you in serious financial trouble.
Being in debt can be a slippery slope, so you should do everything you can to pay off what you owe as quickly as possible. Most banks allow you to pay off a loan early, but it won’t be easy. You have to pay a minimum monthly amount toward that debt, and the minimum won’t get your debt cleared quickly. If you want to be financially stable, know how to pay off a debt early and the pros and cons of doing so.
Advantages of paying off debt early
There are several advantages to paying off your debt early, and almost all of them translate into more money in your pocket each month and more financial freedom to address other goals.
Freedom from monthly payments
The more bills you have to pay, the more complicated and expensive your financial life can get. As you satisfy each of your debts, you’ll have fewer obligations to meet every month. “As a result, your bill-paying process will become easier and faster, and you’ll get to keep more of your money in the bank,” said Leslie Tayne, founder of Tayne Law Group.
In addition to being debt-free faster, paying off debt early offers a mental reprieve that can be hard to quantify. According to a FINRA report, 60% of adults in the United States feel anxious about their personal finances, with high debt being among the major factors for their anxiety.
Save money on interest
When you have high-interest debt, such as credit cards or personal loans, it costs quite a bit just to make minimum monthly payments. In addition, each month you carry a balance on the account, your previous purchases become more expensive due to compound interest. “But, if you pay off the debt in full, you can save a lot of money in interest payments you won’t have to make,” says Tayne.
For example, if you have a $20,000 personal loan with a minimum monthly payment of $400 at 7.5% APR, you’ll pay a total of $4,055.39 in interest charges. If you can afford to pay $200 more per month — for a total monthly payment of $600 — your total interest charge for the loan is $2,497.50. That’s an overall savings of $1,557.89.
Improve your credit profile
When you pay off debt, it decreases your credit utilization ratio, which is the amount of debt you owe relative to the total amount of credit you have access to overall. Reducing your utilization ratio typically improves your credit profile and credit score. As a result, you will likely have access to more favorable interest rates in the future.
“The FICO credit scoring model encourages borrowers to keep their credit utilization ratio at 30% or less,” says Tayne. “That means if you have a $1,000 credit line between your revolving credit accounts, you should keep your total balance owed at or below $300.”
With an improved credit score and greater access to competitive interest rates, your future borrowing needs can be more affordable over your term.
Increase your savings account
One of the biggest advantages of paying off debt is the spare cash you will now have available to address other financial goals and priorities. Ideally, you will use some of the money to increase your savings account, which can help avoid falling into debt again. “If you have a surprise bill, you can cover it without using your credit card and repeating the debt cycle,” says Tayne.
Disadvantages of paying off debt early
It’s usually a good idea to try and pay off your debt as soon as possible, but there are certain situations when it doesn’t make sense.
Less liquidity for investing
If you receive a large sum of money and put it toward your debt, you won’t be able to invest it and earn interest on it. It might make more sense to put that money in an emergency fund, retirement account, or invest it in a high-interest savings account instead.
Possible early-payoff penalty
Additionally, some loans have penalties for early repayment. Know whether your loan comes with this type of hefty financial penalty before paying off the loan early. It may be wiser to put the money into an interest-bearing account instead and continue to make monthly payments toward your loan rather than pay these unnecessary early payoff penalties.
Carefully consider where the money is coming from before using it to pay off your debt. If the money is in savings for emergencies, it may not be wise to deplete that fund, especially if it puts you in a position where you’ll be more likely to use a credit card and rack up new debt at a high interest rate.
How to plan to pay debt off early when you acquire debt
If you’re considering paying off a loan early, there are a few ways to go about it. You don’t necessarily have to make one giant payment. It might be smarter to pay it off sooner with other methods.
Pay extra when you can
One of the most effective ways to pay off your debt before it’s due is to pay more than what you owe. Start by paying more than the minimum amount each month, but only when you have the extra money to spare. Make sure you still have sufficient funds to cover rent, food, childcare, transportation and other daily expenses.
Paying more than the minimum is the only way you’ll make a dent in your debt because it will offset the interest you’re accruing. For example, if the minimum amount is $150, pay $300 when you can instead while maintaining the monthly minimum when tight funds are.
For example, if you receive a work bonus in December, use that money to make an extra payment. Keep in mind that the more you owe and the longer the term of the loan, the more you’ll benefit from making an extra payment.
Make bi-weekly payments instead of monthly
Putting money toward your debt on a bi-weekly basis may make you more accountable than a monthly payment schedule will. This method isn’t the fastest way to pay off your loans, but it’s manageable for most people and will help reduce the amount of interest you’re paying. If you switch to a bi-weekly payment plan, you’ll have made the equivalent of one extra payment every year.
Look into lender payment programs
Some banks and loan providers offer special programs designed to help borrowers pay off their debt more quickly. However, remember that these programs can come with additional fees. Still, lender payment programs can sometimes be worth the hassle or extra money. If you find yourself deep underwater, you could also look into a debt management program through a credit counseling agency.
The bottom line
If you’re struggling with mounting debt, it’s not too late to take action. Create a budget, live within your means and do your best to avoid taking on more debt. In most cases, it’s best to focus on paying off one debt at a time.
If you have student loans, mortgage and credit card debt, figure out which one has the highest interest and work on paying off that one first (hint: it’s likely your credit card). That can keep you from accumulating debt elsewhere or paying too much toward your debt and being unable to pay for necessary expenses like rent.
The first step to financial freedom is repaying your debts as soon as possible. Luckily, there are dozens of resources at your fingertips to help you take charge of your financial situation and live debt-free.