Managing your finances sometimes means making decisions that aren’t always straightforward, like whether to pay off a loan ahead of schedule. While getting out of debt faster can sound appealing, there are a few things to consider before making extra payments.
Here’s a closer look at the benefits and potential drawbacks of paying a personal installment loan early, so you can make the decision that best fits your financial goals.
Key Points
- You can pay off your personal installment loan early, however, your lender may charge you a prepayment penalty.
- There are many pros to paying off your personal installment loan early, including interest savings, a lower debt-to-income ratio, and better cash flow.
- There are also some cons to paying off your personal installment loan early, such as a negative credit impact, a prepayment penalty, and having to pay a large sum upfront, which can impact your savings.
What Is A Personal Installment Loan?
A personal installment loan is a type of loan that’s repaid over time through scheduled, regular payments. Personal installment loans typically have fixed terms, meaning you’ll know exactly when your loan will be paid off if you follow the agreed repayment schedule.
Can You Pay Off A Personal Loan Early?
Whether you can pay off a personal installment loan early depends on your lender. While some lenders allow it, others may charge a penalty for early repayment or prepayments.
Pros Of Paying Off A Personal Installment Loan Early
There are many advantages to paying off a personal installment loan early.
Save Money on Interest
By paying off your loan early, you may reduce the total amount of interest paid over the life of the loan. The quicker you repay the loan, the less time interest has to accrue— which can help you save more money overall.
That said, the earlier you repay the personal loan, the higher the upfront balance will be.
Lower Your Debt-To-Income (DTI) Ratio
With your loan paid off, your DTI ratio will be lower, which is great for any future borrowing needs. Your DTI refers to your monthly debt obligations versus your gross monthly income. For example, if you have $1,200 in monthly debt and an income of $4,000, your DTI ratio would be 30%.
In general, lenders prefer you to have a DTI of 32% or less.
Free Up Your Monthly Budget
Clearing a loan balance means one less payment each month. This can free up cash flow for other priorities, like saving, investing, or handling unexpected expenses.
Moreover, being debt-free can provide peace of mind. Without a loan hanging over your head, you can focus more on reaching other financial goals.
Do You Save Interest By Paying Off A Personal Installment Loan Early?
Yes, as mentioned, one of the main benefits of repaying your personal installment loan early is the money you can save on interest.
For example, if you have a $10,000 loan with a 12% interest rate and a 5-year term, how much can you save if you decide to pay it off at the end of year 3?
In this scenario, you’d have to repay the remaining principal of $4,725.47 at the end of year 3. Doing so would save you $613.19 (Interest paid in years 4 and 5) in interest.
Year | Interest Paid | Principal Paid | Principal Ending Balance |
1 | $1,116.43 | $1,552.90 | $8,447.10 |
2 | $919.48 | $1,749.85 | $6,697.25 |
3 | $697.56 | $1,971.77 | $4,725.47 |
4 | $447.49 | $2,221.84 | $2,503.63 |
5 | $165.70 | $2,503.63 | $0.00 |
Note: Do not forget to compare the savings of early payoff versus any penalties your may incur. The penalties can sometimes take away a significant amount of the savings, making the early loan repayment not wroth it.
Should I Invest Or Pay Off My Personal Installment Loan Early?
Whether you should invest or pay off your personal installment loan depends on whether you think you can earn more than the interest you’re paying on your current loan.
Using the example above, let’s say you invest the $4,725.47 instead of paying your installment loan early and saving $613 in interest.
You continue making your monthly loan payments ($222.44) for 2 years, which equals $5,338.56.
For investing to make sense, the invested amount has to grow enough to cover your loan payments and the amount of money you’d save by paying the loan off early. Essentially, you’d need an ROI of 12% or more.
Example
Investment Interest Rate | Investment Value After 2 Years | Loan Payments Over 2 Years | Difference (Investment – Payments) | Result |
5% | $5,204.64 | $5,338.56 | –$133.92 | You lose money |
6.25% | $5,338.56 | $5,338.56 | $0.00 | You don’t save any money |
8% | $5,509.74 | $5,338.56 | +$171.18 | You save some money, but not as much as paying the loan early. |
12% | $5,926.96 | $5,338.56 | +$588.40 | Almost equal to the interest saved if paid early |
15% | $6,261.73 | $5,338.56 | +$923.17 | Better to invest |
In this scenario, given that the likelihood of a 12%+ increase in your investment is low, you’re better off paying the loan early.
Learn more: How To Save Money And Pay Off Debt
Does Paying Off A Personal Installment Loan Early Build Your Credit?
Successfully paying off a loan shows lenders that you can manage debt responsibly. Depending on your full credit profile, it could help strengthen your credit score by showing positive repayment history.
Can Paying Off A Personal Installment Loan Early Hurt Your Credit Score?
Paying off your personal installment loan early may negatively affect your credit score in a few ways:
- Credit Mix – Your credit score benefits from having a variety of credit types. Paying off and closing an installment loan might slightly lower your “credit mix,” though in most cases, the impact is minor and temporary.
- Credit History – The age of your credit accounts will also be affected by the closure of your loan account, which may negatively impact your credit scores.
- Payment History – While paying off your personal installment loan early won’t impact your payment history, you indirectly affect it. By paying the loan early, your taking away the opportunity to build a longer, positive payment history.
Learn more: How Applying For New Credit Affects Your Credit Scores
Cons Of Paying Off A Personal Installment Loan Early
Just as there are benefits to paying off a personal installment loan, there are certain cons to be aware of as well.
Prepayment Penalties May Apply
Some lenders charge a fee if you pay off your personal installment loan before the end of the term. These prepayment penalties are meant to recover lost interest. Always check your loan agreement or ask your lender about any potential charges.
Draining Your Savings
If you’re thinking about paying off a personal installment loan early, you may need to come up with a significant amount of cash to pay upfront. If you’re using all your available cash to pay off a loan, it could leave you without enough savings for emergencies. As such, it’s important to maintain a balance between paying off debt and keeping an emergency fund.
Tips On How To Pay Your Personal Installment Loan Quickly
- Opt for bi-weekly payments – Instead of monthly payments, opt for bi-weekly payments. While your payments will be around half of what your monthly payments are, this payment method allows you to naturally make 2 extra payments a year.
- Make extra payments – If there are no penalties for prepayment, you can make extra payments periodically. These payments will go directly toward the principal amount, which can help you pay your loan faster and save you money on interest.
- Automate your payments – Late payment fees, NSF fees, and other costs can make your loan more expensive. To avoid any penalties and extra interest costs, automate your payments, so you don’t miss any payments.
How To Decide If Early Payoff Is Right for You
The decision to pay off a loan early depends on your full financial picture.
Here are a few important questions to consider:
- Are there prepayment penalties?
- Will paying off the loan drain your emergency savings?
- Are there higher-interest debts you should prioritize first?
- Does paying off the loan help you achieve larger financial goals?
If early repayment leads to savings, reduces your financial stress, and doesn’t put you at risk of running low on cash, it could be a smart move. But if the costs outweigh the benefits, it may be better to stick to your original payment schedule.
Bottom line
Paying off a personal installment loan early can have big upsides, like saving money on interest, reducing monthly expenses, and giving you greater financial freedom. But it’s important to consider potential downsides like fees, credit score impacts, and cash flow challenges. Taking the time to weigh the pros and cons can help you make the best decision for your financial future.