Perhaps you’ve gotten a raise or a bonus, and you want to pay off the remaining balance on a personal loan. Is that possible? The short answer is “yes” and, in many cases, it can be a wise decision.
But if there’s a prepayment penalty, then this loan payoff may be more costly than you’d expect. Learning how a prepayment penalty might affect your payoff amount can be helpful in making the decision whether or not to pay off a personal loan early. And if you’re gathering information about a personal loan early payoff without incurring a prepayment penalty, you do have some options.
Is It Possible to Pay Off a Personal Loan Early?
It’s unlikely that a lender would refuse an early loan payoff, so yes, you can pay off a personal loan early. What you have to calculate, though, is whether it’s financially advantageous to do so. If a personal loan early payoff triggers a prepayment penalty, it might not make financial sense to do so.
Overview of Prepayment Penalties
It may sound strange that a lender would include this kind of penalty in a loan agreement in the first place.
Some lenders may, though, to ensure you’ll pay a certain amount of interest before the loan is paid off. It is an extra fee that, when charged, helps lenders recoup more money from borrowers.
You can find out if you’d be charged with a prepayment penalty by looking at the loan agreement you signed with the lender.
If you have one, the penalty could be in effect for the entire loan term or for a portion of it, depending upon how it’s defined in the loan agreement.
Does Paying off a Personal Loan Early Affect Your Credit Score?
Personal loans are a type of installment debt. In the calculation of your credit score, your payment history on installment debt is taken into account. If you’ve made regular, on-time payments, your credit score will likely be positively affected while you’re making payments during the loan’s term.
However, once an installment loan is paid off, it’s marked as closed on your credit report — “in good standing” if you made the payments on time — and will eventually be removed from your credit report after about 10 years. Paying off the personal loan early might cause it to drop off of your credit report a few earlier than it would have and no longer help your credit score.
If I Pay Off a Personal Loan Early, Does My Interest Rate Decrease?
Since a personal loan is an installment loan with a fixed end date, if you pay off a personal loan early, you won’t pay less interest. You won’t owe any interest anymore because the loan will be paid in full.
Recommended: What are the average personal loan rates?
Advantages of Paying off a Personal Loan Early
There are definitely some advantages to personal loan early payoff. One obvious benefit is that you could save on interest over the life of the loan. A $10,000 loan at 8% for 5 years (60 monthly payments) would accrue $2,166.50 in total interest. If you could pay an extra $50 each month, you could pay the loan off 14 months early and save $518.42 in interest.
Not owing that debt anymore can be a psychological comfort, potentially lowering bill-paying stress. If you’re able to make that money available for something else each month — maybe creating an emergency fund or adding to your retirement account — it might even turn into a financial gain.
If you no longer owe the personal loan debt, you’ll essentially be lowering your debt-to-income ratio, which could positively affect your credit score.
Disadvantages of Paying off a Personal Loan Early
If your personal loan agreement includes a prepayment penalty, paying off your personal loan early might not be financially advantageous. Some prepayment penalty clauses are for specific time frames in the loan’s term, e.g., during the first year. If you pay off the loan during the penalty time frame, it could cost you just as much money as it might if you had just paid regular principal and interest payments over the life of the loan.
You might be thinking of a personal loan early payoff so you can put your money to work somewhere else. But if the interest rate on the personal loan is relatively low, it might make financial sense to put your extra money toward higher-interest debt, or to contribute enough to an employer-sponsored retirement plan so you can get the employer match, if one is offered. If you don’t have an emergency fund yet, you might also consider starting one with a bit of extra money each month until it’s at a comfortable level.
Another thing to consider is whether paying off your personal loan early will hurt your credit. As mentioned above, making regular, on-time payments to an installment loan like a personal loan can have a positive effect on your credit score. But when the loan is paid off, and marked as such on your credit report, it’s not as much help.
| Advantages of early personal loan payoff | Disadvantages of early personal loan payoff |
|---|---|
| Interest savings over the life of the loan | Possible prepayment penalty |
| Could alleviate debt-related stress | Extra money could be better used in another financial tool |
| Lowering your debt-to-income ratio | Removing a positive payment history on the loan early could negatively affect your credit |
| More cushion in your monthly budget | Taking money from another budget category might leave an unintentional financial gap |
Things To Ask Yourself Before Paying off a Personal Loan Early
Everyone’s financial situation is different. Priorities that are important to you might be less so to someone else. Considering how a personal loan early payoff might affect you can be a good way to start making the decision.
Will Paying off a Personal Loan Early Put Me at Risk?
There can be some drawbacks to paying off a personal loan early — some that might be considered risks.
If you’re thinking of putting extra money toward a personal loan balance, but you don’t have any money set aside in an emergency fund, that’s a financial risk. If you encounter an expensive, necessary financial need without the means to pay for it, you might be tempted to use high-interest debt like a credit card.
If you consider it risky to pay more than you need to for something, then paying a prepayment penalty could be considered a financial risk. If paying a loan early will cost you extra money, you might think about where that money could be better spent.
Will Paying off a Personal Loan Early Improve My Debt-To-Income Ratio?
Lowering your debt-to-income ratio can have a positive effect on your credit score, and paying off a loan will accomplish this. But you might weigh that positive against any potential negative effect that might come with paying off your personal loan early, such as not having a positive payment history included on your credit score after your loan is closed.
Does Paying off a Personal Loan Early Have Clear Benefits?
There are absolutely clear benefits to paying off a personal loan early. Saving money in interest charges over the life of the loan is at the top of the list, as long as any savings is not offset by a prepayment penalty.
Having more money in your monthly budget — since you wouldn’t have that loan payment due each month — might lower your financial stress.
Types of Prepayment Penalties
If and how a prepayment penalty is charged on a personal loan will be stipulated in the loan agreement. Reviewing this document carefully is a good way to find out if the penalty could be charged and how your lender would calculate it.
If you can’t find the information in the loan agreement, asking your lender for the specifics of a prepayment penalty and for them to point out where it is in the loan agreement is another way to be certain you have the right information to make a decision.
There are a few different ways a lender might calculate a prepayment penalty fee.
Interest costs
In this case, the lender would base the fee on the interest you would have paid if you had made regular payments over the total term. So, if you paid your loan off one year early, the penalty might be 12 months’ worth of interest.
Percentage of your remaining balance
This is a common way for prepayment penalties to work on mortgages, for example, and you’d be charged a percentage of what you still owe on your loan.
Flat fee
Under this scenario, you’d have to pay a predetermined flat fee for your penalty. So, whether you still owed $9,000 on your personal loan or $900, you’d have to pay the same penalty.
Avoiding Prepayment Penalties
Finding out whether a prospective lender charges a prepayment penalty — and not using that lender if it does — is at the top of the list of ways to avoid a prepayment penalty.
If you’ve already taken out a loan that includes a prepayment penalty, there are some options.
First, you could simply decide not to pay the loan off early. This means you’ll need to continue to make regular payments on the loan rather than paying off the balance sooner, but this will allow you to avoid the prepayment penalty fee.
You could also talk to the lender and ask if the prepayment penalty could be waived, but there is no guarantee that this strategy will succeed.
If your prepayment penalty is not applicable throughout the entire term of the loan, you could wait until it expires before paying off your remaining balance.
Another strategy is calculating the amount of remaining interest owed on your personal loan and comparing that to the prepayment penalty. You may find that paying the loan off early, even if you do have to pay the prepayment penalty, would save money over continuing to make regular payments.
Types of Personal Loans
In general, there are two types of personal loans — secured and unsecured. Secured loans are backed by collateral, which is an asset of value owned by the loan applicant, such as a vehicle, real estate, or an investment account. Unsecured personal loans, on the other hand, are backed only by the borrower’s creditworthiness, with no asset attached to the loan.
You might hear unsecured personal loans referred to as signature loans, good faith loans, or character loans. Typically, these are installment loans the borrower repays at a certain interest rate over a predetermined period of time.
Personal Loan Uses
Acceptable uses of personal loan funds cover a wide range, including, but not limited to:
• Consolidation of high-interest debt.
• Medical expenses not covered by health insurance.
• Home renovation or repair projects.
• Wedding expenses.
While there are benefits to borrowing a personal loan, it might not always be the right financial move for everyone. Personal loans offer a lot of flexibility, but they are still a form of debt, so it’s a good idea to weigh the pros and cons before signing a personal loan agreement.
Awarded Best Personal Loan of 2022 by NerdWallet.
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Personal Loans at SoFi
If you’re looking for an unsecured personal loan with no prepayment penalties, a personal loan from SoFi might fit your financial need. There are no application fees, no origination fees, and no hidden fees attached to unsecured personal loans with SoFi.
A SoFi Personal Loan can be used to consolidate credit card debt, make home improvements, pay for relocation costs, repair your vehicle, make a major personal purchase and more.
The Takeaway
If you’re in a secure enough financial position to be able to pay off your personal loan early, that’s terrific. But before you do, it’s a good idea to calculate whether it’s a good financial decision or not. A prepayment penalty could take a bite out of any savings you might see on interest costs.
Comparing interest rates for a personal loan, along with lenders’ fees and other charges, including prepayment penalties, is a good way to find the lender that meets your financial needs.
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FAQ
Is it good to repay a personal loan early?
Paying off a personal loan early can be a good financial decision, as long as any prepayment penalty charge doesn’t cost more than you might pay in interest.
If I pay off a personal loan early do I pay less interest?
Paying off a personal loan early doesn’t affect the interest rate you’ve been paying up until that point. It would mean, however, that the total amount of interest you’d pay over the life of the loan would be less than anticipated.
Does paying off a personal loan early hurt your credit?
Because making regular, on-time payments on an installment loan such as a personal loan is a positive record on your credit report, removing that history early can have a slight negative affect on your credit.
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Source: sofi.com