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 certainly come in handy from time to time.
Of course, when you take out a loan, you’ll want to make sure that you’ll be financially capable of making your payments every month 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?
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.
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.
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.
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, 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.
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:
You may be able to avoid prepayment penalties by having a certain kind of mortgage:
Generally, your prepayment penalty will be the higher of these two amounts:
OR
Lenders may use the IRD calculation if you signed your mortgage contract less than 5 years ago, and if your mortgage rate is higher than the current interest rate. The way the IRD is calculated depends on your mortgage rate. When you sign a mortgage, your rate can be higher or lower (discounted rate) than the lender’s posted (advertised) rate.
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 pay 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 details of the contract to pay attention to, prepayment penalties are an important one.
Lenders make money on 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.
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.
There are certain benefits to paying off your loan early that are fairly obvious but worth mentioning. These include:
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.
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.
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.
Although it’s better than being late, paying a loan off early has some downsides:
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.
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.
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.
The rate you’re charged on a loan depends on a number of factors, such as your credit score, the loan amount you require, the loan type, the collateral (if applicable), and the lender. But there are variations of interest that you should be aware of.
Since saving on interest is one of the main reasons why someone would want to pay off their loan early, it’s important to understand the difference between simple and precomputed interest. More specifically, understanding these types of interest may influence whether or not you decide to pay off a loan early, as we’ll explain.
Simple interest is paid on the principal amount that is taken out. It is not compounded. So, if you take out $5,000, for instance, you’ll only pay interest on that $5,000 without any compounding involved. It’s the fact that the interest is not compounded which makes simple interest attractive to borrowers.
Since each payment on a loan with simple interest charged reduces the principal amount by a certain margin, the principal amount will be lower on the next payment compared to the previous payment. As such, less interest would be due on the principal amount while more of the payment would go toward paying down the principal. Mortgages and other conventional installment loans work this way.
Precomputed interest is a way to calculate loan payments by adding all the interest that would be due over the loan term to the principal amount and then splitting it into monthly payments. No separate interest and principal calculations are done on a precomputed interest loan because of the combination of the interest and principal at the time that the loan is taken out.
Considering this fact, paying off your loan early on a precomputed interest loan might not be nearly as beneficial as it would be with a simple interest loan.
There are many situations in which paying off your loan early can be beneficial, such as the following:
There are literally dozens of ways to save up money to pay off a loan early. Here are just a few suggestions:
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.
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Bryan is a graduate of Dawson College and Concordia University. He has been writing for Loans Canada for five years, covering all things related to personal finance, and aims to pursue the craft of professional writing for many years to come. In his spare time, he maintains a passion for editing, writing screenplays, staying fit, and travelling the world in search of the coolest sights our planet has to offer.
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