Can You Pay a Loan Off Early?
It is absolutely possible to pay a loan off early either by making larger monthly payments, which can reduce your repayment term, or by paying off the entire balance at once. However, you may not always want to pay your loan off early.
Some lenders — not all — charge a prepayment penalty, so it’s worth checking your loan agreement before you decide to pay your loan off ahead of schedule. A prepayment penalty’s amount can vary depending on the lender and specific loan type and amount. Typically, prepayment penalties can be charged in one of three ways:
- A percentage of your loan amount
- A portion of the interest your lender is missing out on
- A fixed fee
It’s important to note that the best personal loans do not have prepayment penalties. In fact, prepayment penalties are generally regarded by regulatory agencies as predatory lending practices. Before taking out a new loan, it’s a good idea to first check your loan agreement to see if the lender will charge a prepayment penalty.
Should You Pay a Loan Off Early?
Even if your loan terms don’t include a prepayment penalty, you may still want to pause before paying a loan off early. Before you make a decision, consider the following factors:
- Your potential savings on interest: An online debt payoff calculator can show you exactly how much you’ll save using different repayment strategies, such as making larger monthly payments or a single lump sum payment. Once you know how much you’ll save in interest, weigh the upside against the factors below.
- Your current financial situation: Will paying off your loan early deplete your emergency fund or strain your budget? If you don’t have emergency savings or you would have to use your emergency fund to pay off your loan, it may be better to wait until your emergency savings are fully funded first. If you are looking to improve your emergency savings, check out our list of the best savings accounts.
- Your financial goals: Consider your other financial goals in relation to the reward of paying your loan off early. For example, if one of your financial goals is to save more for retirement, determine whether your retirement investments could earn higher interest than the rate you’re paying on your loan. If your loan has a relatively low interest rate, you may want to forgo paying it off early in lieu of investing your extra cash in your retirement account.
Ultimately, it’s important to weigh both financial and emotional factors when making this decision. For some people, the emotional burden of carrying a high amount of debt can be substantial. The opportunity to remove that stress might outweigh any potential financial benefits of choosing not to pay a loan off early.
Pros and Cons of Paying a Loan Off Early
Everyone’s financial situation is different, so it’s important to weigh the pros and cons of paying a loan off early in the context of your own circ*mstances.
Pros
Interest savings: You’ll save money on interest costs that otherwise would have gone to your lender.
Lower debt-to-income ratio: Lowering your DTI ratio may result in a higher credit score and more favorable loan terms in the future.
Freedom from debt: You’ll enjoy the emotional and mental benefits of being debt-free.
Cons
Possible prepayment penalty: If your loan has a prepayment penalty, you may owe hundreds or thousands of dollars to the lender for the privilege of paying your loan off early.
Potential credit score implications: While you’d think paying your loan off early would improve your credit score, you might experience a temporary hit because the credit bureaus are no longer recording consistent on-time payments.
Opportunity cost: Paying your loan off early could prevent or delay you from building up your savings or investments, making it difficult to reach other financial goals.
Types of Loans You Should Consider Paying Off Early
The decision to pay a loan off early is highly personal and dependent on multiple factors. With that said, it often makes sense to pay off certain types of loans early when possible. These loans include the following:
- High-interest credit card debt
- High-rate personal loans
- Short-term loans with high APR
High-Interest Credit Card Debt
Credit cards carry some of the highest interest rates compared to other types of debt, including personal loans. In 2023, average interest rates on credit cards are above 20%, making this type of debt very expensive. If you have extra money in your budget, paying down high-interest credit card balances early may save you a substantial amount of interest and significantly reduce the length of your repayment periods.
High-Rate Personal Loans
Similarly, high-rate personal loans can be a strain on your budget and cost you hundreds or thousands of dollars in interest in the long run. In 2023, average rates on a two-year personal loan are above 11%. While that interest rate may be comfortable for some budgets, it can place a real burden on others. Paying high-rate personal loans off early can save money in interest and free up cash in the monthly budget faster.
Short-Term Loans With High APR
Payday loans, pawnshop loans and other short-term loans with a high annual percentage rate (APR) are also good candidates for early repayment when possible. These types of loans often have repayment terms of two to four weeks with an APR approaching 400%.
Borrowers with these types of loans are especially susceptible to falling into a debt cycle, as they often have to apply for another loan shortly after paying off the balance of the last one. For these reasons, allocating any extra money toward the repayment of short-term high-APR loans makes sense.
Strategies for Paying a Loan Off Early
If you’ve determined that paying a loan off early will help you reach your goals, there are a number of strategies you can use to do so. Some tactics include the following:
- Making extra payments
- Allocating windfalls or bonuses
- Implementing biweekly payments
Making Extra Payments
Making extra or larger payments toward your loans is one of the simplest ways to pay your loan off early. Essentially, extra payments decrease the size of the principal balance faster. Whenever you’re making extra or larger payments, be sure to communicate to the lender that any extra should be applied to the principal only, not the interest.
If you’re using this strategy, it’s important to remember that any extra payment helps — you don’t necessarily need to be consistent. This strategy can be useful for borrowers with fluctuating incomes where they may have more money available in the budget one month but less in another.
Allocating Windfalls or Bonuses
Allocating windfalls or bonuses is another good strategy for paying off a loan early, especially if you have trouble making extra or larger payments from your regular income. Extra windfalls or bonuses are typically inconsistent. Receiving a bonus from your job, an inheritance, a gift or even a tax refund could be considered a windfall.
Anytime you receive a windfall, plan to allocate a percentage of it — or the full amount — toward your debt balance. Knocking out a large portion of your loan at once can be particularly satisfying. Again, make sure to communicate with your lender that any extra payments you’re making should be applied to the principal.
Implementing Biweekly Payments
Making biweekly loan payments rather than monthly payments can be a particularly effective strategy because it aligns with many people’s pay periods and can result in significant savings with minimal strain to the budget.
With this strategy, you pay half your monthly payment every other week rather than making the full payment once a month. Over a year, this results in 26 half-payments — or 13 full payments as opposed to 12 full payments. Those two extra half-payments speed up the rate at which you pay off the loan.
The Bottom Line
The decision to pay off a loan early is highly personal and should be weighed carefully. While saving money on interest is undoubtedly a benefit, consider the potential downsides to paying a loan off early, such as any prepayment penalties in your loan terms, before making a final decision.
Additionally, personal financial circ*mstances should be an important factor in deciding whether to pay a loan off early. Your financial stability, future goals and emotional feelings toward debt are all valid considerations. Evaluating these things alongside your loan terms can help you make the most informed decision.
Frequently Asked Questions About Paying a Loan Off Early
In general, it makes sense to pay off high-interest loans as quickly as possible. High-interest loans, such as credit cards and payday loans, are expensive and can add substantial strain to your monthly budget. Making extra payments toward these loans whenever possible can shorten the amount of time you’ll spend repaying these loans and save you money in interest.
Not always. It’s important to clearly communicate to your lender that any extra payments you’re making should be applied to the principal balance. Paying down the principal balance first will save you money in interest and shorten the repayment period.
The three C’s of credit are character, capital and capacity. Character refers to your credit history or creditworthiness, which is determined by your credit reports and expressed numerically as your credit score. Capital refers to the collateral you have available to repay your loan should you not be able to make your payments, such as a house for a mortgage or a car for an auto loan. Capacity refers to your financial ability to pay back the debt and is often determined by your income and employment.
A credit score is a numerical representation of your credit history or creditworthiness. There are multiple credit scoring companies in the U.S., but the most common credit score used by lenders is the FICO score. The FICO score is calculated based on five categories, each of which is weighted differently: your payment history (35%), the amount of debt you owe (30%), the length of your credit history (15%), new credit applications (10%) and your credit mix (10%).
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
If you have feedback or questions about this article, please email the MarketWatch Guides team ateditors@marketwatchguides.com.
Hillary GaleContributing Writer
Hillary Gale is a personal finance writer who focuses on financial planning, investing, and money mindsets. She is the CEO and founder of Gale Creative Agency, a boutique digital marketing firm that develops marketing strategies and content for financial services brands. Hillary has been published in Clever Girl Finance and Wealthtender.
Jen Hubley LuckwaldtEditor
Jen Hubley Luckwaldt is an editor and writer with a focus on personal finance and careers. A small business owner for over a decade, Jen helps publications and brands make financial content accessible to readers. Through her clients, Jen’s writing has been syndicated to CNBC, Insider, Yahoo Finance, and many local newspapers. She is a regular contributor to Career Tool Belt and Career Cloud.
