There are certain times in life when a little financial help would be helpful. Whether it’s to purchase a car, buy a home, or cover the cost of college tuition, a loan can come in handy.
Of course, when you take out a loan, you’ll want to make sure that you’ll be financially capable of making your payments until the full amount is repaid. But what if you stumble upon some extra cash that you have available to be put toward your loan? What if you’re able to pay off your loan early, allowing you to save money on interest?
Key Points You Should Know
- You can pay off most loans early, however, you may be charged a prepayment penalty.
- Check your loan agreement or speak to your lender to determine whether or not you’ll be charged a fee for paying off your loan early.
- Paying off your loan early may be worth it if there are no penalties or the savings significantly outweigh the penalty costs.
Can You Pay Off A Loan Early?
Yes. Most lenders will let you pay off your loan ahead of time, but it depends on how your lender operates. Some lenders accept early payments without penalty, while others will charge you a prepayment fee. So, before you apply, make sure to call your lender and check your loan agreement to find out if they charge prepayment penalties.
What Is A Prepayment Penalty?
A prepayment penalty is exactly what it sounds like: a financial charge that you would be subject to if you pay off the loan in full or more than the agreed payments before the maturity date. The prepayment penalty rate – and whether or not one exists at all – will be specified in your loan contract. That said, the penalty cost usually lowers the longer you’ve had your loan and the less you owe on it.
Can You Pay Off A Personal Loan Early?
If your personal loan lender accepts prepayments, you can pay your loan off early without penalty. However, in some cases, a lender will accept prepayments if you pay a prepayment penalty fee. The average prepayment penalty can cost around 4%-5% of your unpaid balance.
Can You Pay Off A Car Loan Early?
Most car loan lenders will let you get out of your car loan early by making larger payments or covering your remaining balance with a lump sum payment. Many drivers will do this to save on interest and reduce their debts after getting a raise at work or a windfall of cash.
However, do note, that some auto lenders will charge you a prepayment fee, though that penalty could cost less than the interest and fees you’ll pay to finish your full car loan term.
Learn more: How To Get Out Of Your Car Loan
Can You Pay Off A Mortgage Early?
Yes, you can also pay off your mortgage ahead of time, as long as you’re comfortable with the possibility of being charged prepayment fees (or ‘breakage’ costs) for:
- Breaking the conditions of your mortgage agreement
- Making larger mortgage payments than you’re supposed to
- Paying off your full mortgage before your term ends (including selling your home)
- Transferring your mortgage to a different lender before your term is over
Learn more: How To Pay Off Your Mortgage Early In Canada
Can You Avoid The Mortgage Prepayment Penalty Fee?
You may be able to avoid prepayment penalties by having a certain kind of mortgage:
- Open Mortgage – This type of mortgage is made for borrowers who prefer flexibility when it comes to their payment plans. You can pay back an open mortgage whenever you want, without incurring any prepayment penalties.
- Closed Mortgage – A closed mortgage has a specific limit for the amount of principal you can pay off per year. However, most come with prepayment privileges (a clause that lets you make prepayments without penalty). This exact amount will vary by lender, but can go as high as 20% to 30% of your original mortgage balance.
| How Much Is The Mortgage Prepayment Penalty? Generally, your prepayment penalty will be the higher of these two amounts: – 3 months’ interest on your outstanding balance – The interest rate differential (IRD) – is the difference between the interest rate you’re currently paying on your mortgage and the rate you could get for a new mortgage on the remaining term of your current mortgage. |
If You Pay Off A Loan Early, Do You Pay Less Interest?
Yes, if you pay off your loan early, you’ll pay less interest overall.
Here’s why: Loans with simple interest calculate interest based on the principal. Since each loan payment you make reduces the principal amount by a certain amount, the interest charged on the next payment lowers. As such, when you make early payments, you reduce the principal balance faster and thus pay less interest.
This principle applies to mortgages and most other traditional installment loans that charge simple interest.
How Much Would You Save?
To illustrate how powerful prepayments can be, let’s assume you have a $20,000 loan with a 5-year term and a 12% interest rate.
| Regular Payments | With Extra Payments | |
| Monthly pay | $444.89 | $444.89 |
| Extra Payments | $0 | $200 |
| Total payments | $26,693.34 | $24,061.92 |
| Total Interest Paid | $6,693.34 | $4,061.92 |
| Total Interest Saved | $0 | $2,631.42 |
| Payoff in | 5 yrs | 3 yrs, 2 mos |
How Do I Know If My Lender Allows Prepayments?
To find out if a prepayment penalty provision exists, check your loan agreement. There, you should find out how much you would be charged if you paid off your loan before its original due date.
There’s a lot of fine print on a loan contract that outlines all the nitty-gritty about your obligations, which is why it’s important to read your contract in detail before you sign on the dotted line. And among all the contract details to pay attention to, prepayment penalties are one of the most important.
Why Do Lenders Charge A Fee For Paying Off A Loan Early?
Lenders make money through the interest paid on a loan. As such, if you pay the loan off early, that profit would be slashed. To recoup their losses, some lenders may charge a prepayment penalty.
Does Paying Off A Loan Early Affect Your Credit?
Paying your loan off early won’t automatically lower or raise your credit score, however, it could affect your credit history as that account would close once you pay it off.
Moreover, paying your loan early would also affect your payment history as no more payments would be reported. If you make all of your payments as agreed, it can help you improve a bad credit score and maintain a healthy credit history while the loan is active.
Only revolving credit products, like lines of credit and credit cards, can raise your credit score when you make early payments. Paying revolving credit off early can lower your credit utilization rate, which can boost your score.
Benefits Of Paying Off Your Loan Early
There are certain benefits to paying off your loan early that are fairly obvious but worth mentioning. These include:
Saving Money On Interest
When you take out a loan, your lender will charge you a certain interest rate in exchange for loaning funds to you. It’s how they make money; the higher the rate, the more expensive the loan will be for you. But if you can pay off your loan early, you could save yourself hundreds or even thousands of dollars that would otherwise have been spent on ongoing interest charges. The ability to save that kind of money is a huge benefit of paying off your loan early.
Get Out Of Debt Early
Of course, if you repay your loan in full earlier than expected, you can get yourself out of debt much faster. If you’re like most other Canadian consumers, you likely have a variety of loans and credit accounts, including a mortgage, car loan, or credit card.
By getting rid of one loan, you can reduce the amount of debt you carry, which is not only good for your credit score and financial profile but can also relieve any stress you may have from carrying a lot of debt.
One Less Payment To Make
Debt payments can really add up, which can put a lot of strain on your finances. By paying off a loan early, you can eliminate one more monthly payment and free up more money to be used for other expenditures.
Drawbacks Of Paying Your Loan Off Early
Although it’s better than being late, paying a loan off early has some downsides:
It Can Lead To Prepayment Penalties
Basically, if you defer from your original loan agreement in some way, your lender might charge you for it. The size of your penalty varies according to the conditions of the prepayment and loan contract.
It Won’t Help Build Your Credit (And May Hurt It)
When you close a credit account, you reduce the number of open credit accounts you have. So, your credit score won’t get the same boost as it would if you finished your original payment plan.
The Extra Payments Could Be Used To Invest
Stock market return rates can be higher than mortgage interest rates. In that case, you can make more money by investing your spare funds than by using them to pay your mortgage early.
When Is It The Right Choice To Pay Off A Loan Early?
There are many situations in which paying off your loan early can be beneficial, such as the following:
- Your prepayment penalty is less than the interest you would pay
- You can afford the prepayment penalty and want to be debt-free
- You want to reduce your debt-to-income ratio
- You want more peace of mind knowing you’ve got less debt than you owe
How To Save Up To Pay Off Your Loan Early
There are dozens of ways to save up money to pay off a loan early. Here are just a few suggestions:
- Budget – A budget is one of the most effective ways of saving money. It can not only help you track your spending but pinpoint bad spending habits.
- Automate Your Savings – Instead of manually moving money to your savings account, have it automatically do so. You can also increase your savings by opting for accounts that round up your purchases and put them into savings.
- Invest – To accelerate your savings, put the money in a high-interest savings account to earn interest. You can also use your TFSA to help grow your savings tax-free
- Pay Off Higher-Interest Rate Debt First. If you have other debts, be sure to pay off the loans with higher interest first to avoid accumulating interest.
- Passive Income – The more income you make, the more money you can save. By implementing a couple of passive income strategies, you can save up even more money.
Final Thoughts
Paying off a loan early is possible but it’s not always the best idea. If your lender charges a prepayment penalty, paying off your loan early won’t save you any money. Therefore, it is likely not worth the effort. But, if you have the extra cash and can come to an affordable agreement with your lender, then paying off your loan and having one less thing to worry about could be the right choice for you.
