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There are certain times in life where 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 our loan early, allowing you to save money on interest?
Do you know how lenders set their interest rates? Find out here.
How Will You Benefit From Paying Off Your Loan Early?
There are certain benefits to paying off your loan early that are fairly obvious but are 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, and the higher the rate is, the more expensive the loan will be for you. But if you’re able to pay off your loan early, you can save yourself hundreds or even thousands of dollars that would otherwise have been spent in 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 it 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.
For more information about how loan repayment affects your credit score, click here.
Simple Interest Vs. Precomputed Interest
As already mentioned, loans come with interest rates to give lenders a stream of income. The rate you’re charged will depend on a few things, 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 what the difference between simple and precomputed interest is. More specifically, understanding these types of interest may influence whether or not you decide to pay off a loan early, as we’ll explain.
Check out our article, Interest 101, for even more information about interest rates.
Simple interest – 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 installments loans work this way.
Precomputed interest – 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. No separate interest and principal calculation is 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.
What is a Prepayment Penalty?
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.
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 before the maturity date. Lenders like making loans because they make money on interest, so if you pay the loan off early, that profit would be slashed. And to recoup their losses, they may charge a prepayment penalty.
The prepayment penalty rate – and whether or not one exists at all – will be specified in your loan contract. That said, penalties are usually smaller the less you owe and the longer you’ve had your loan. Be sure to find out if a prepayment penalty provision exists on your contract and how much you would be charged if you pay off your loan before its original due date.
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 to save money on interest
- The money saved in interest is much more than any prepayment penalty charged
- You want to improve your credit score
- 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 literally dozens of ways to save up money to pay off a loan early. Here are just a few suggestions:
- Cut down on spending
- Put a certain percentage or amount of money away each paycheck and deposit into a savings account
- Automate your savings
- Pay down your higher-rate loans first to free up more money
- Reduce waste of energy in the home
- Use your credit cards wisely
- Take a grocery list with you when you go shopping and stick to it
- Sell items you haven’t used in at least 6 months
- Move bank accounts around to benefit from perks to earn more interest
- Don’t eat out
- Negotiate interest rates with your credit card provider
- Cancel any little-used club memberships
FAQs About Early Loan Payment
Will paying off a loan affect my credit score?
Paying off a loan won’t harm your credit score, but keeping it open for the full term and being responsible with all payments can actually be a good thing for your credit score. As such, sometimes it pays to leave these accounts open.
Will my lender let me pay off my loan after a month?
Again, this will depend on the specifics of your particular loan and what the exact rules are. If a prepayment penalty exists, your lender may allow you to pay off the loan early, but not without some form of prepayment penalty being charged and paid first.
How do I pay off my loan early?
In order to pay off your loan early, it’s not as simple as dumping extra money into your loan account. Instead, you’ll need to discuss your desires with your lender in order to arrange for early loan repayment.
If you’re looking for a loan or advice on paying off a loan early, turn to loans Canada for help. We can provide you with the advice you need to make responsible financial decisions and can put you in touch with a sound lender in the event that a loan is needed.
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