Here's a question you might be asking yourself if you're paying off a personal loan. Is it okay to pay off the whole amount before the final due date?
The obvious answer is yes. Who wouldn't want to get rid of a loan and loan payment?
But...not so fast. In some instances, paying off personal loans might be a good strategy. But in other cases, the drawbacks of paying that loan off at once could create more problems. It could also be more expensive.
So, should you pay that loan off early? Read on to learn the advantages and disadvantages of doing so.
Pros of Paying Off a Personal Loan Early
Here are the advantages if you want to pay a loan off early.
Elimination of Monthly Payments
Paying off personal loans before they're due helps eliminate that bi-weekly or monthly recurring payment so you have more money for other needs. That extra cash could take care of daily expenses. Or you could save that money for emergencies or stash it in a retirement fund.
Debt-to-Income Ratio Reduction
One less loan can help reduce your debt-to-income (DTI) ratio. Dividing your total debts by your total income gives you the DTI. A lower DTI can be helpful if you need to consider financing options for things like buying a house or car. A lower DTI also means a better credit score.
Savings on Interest
All personal loans - especially longer-term installment loans - come with interest payments. This amount is what the lender collects from you as payment for providing you with financing. Longer-term loans mean you're paying more in interest. But paying that loan off earlier reduces the interest amount you owe, which could put more cash in your pocket.
Here's an example. Let'sSuppose you decide to finance a car with 60 loan payments totaling $46,423.23. This amount includes other costs, like tax, title, and registration. Assuming the loan carries a 5% interest rate, you'll owe $5,423.23 in interest payments on top of the principal. If you pay the loan off by the end of the second year, you'll save more than $2,000 in interest payments.
More Financial Comfort
Peace of mind isn't always measured in dollars and cents. But it's essential when it comes to getting rid of debt. Paying off that loan means one less worry. Even better, one less loan means you're getting closer to a debt-free status. This achievement can mean a great deal, especially if you've had past credit and money issues.
Cons of Paying Off a Loan Early
Reducing debt and interest payments - and improving your DTI - are great reasons to pay the loan off early. But the following issues might outweigh those advantages.
Prepayment Penalties
As mentioned above, paying the loan off early means you can end extra interest payments. But this means the lender misses out on those interest payments. To recoup those losses, your loan might carry a prepayment penalty, which is a percentage of your remaining principal loan balance. The average prepayment penalty charge is 2% of the outstanding principal balance.
Even with the prepayment penalty, paying off your loan could still save you money. But if your loan has a lower, fixed-interest rate, that penalty could erode benefits from an early payoff.
Be sure to check the fine print of your contract before considering an early loan payoff. Some lenders charge a prepayment penalty, while others don't - like Jora Credit.
Credit-Score Ding
There are situations when paying off that loan early might actually hurt your credit.
Here's why.
Credit reports classify your personal loan as an installment loan. This lists the loan's entire amount and repayment schedule.
Here's the problem when you pay that loan off early. A good part of your FICO score - 35% - considers your payment history and on-time payments. Paying the loan before its due date shortens that history, which could impact your credit score.
Second, your credit mix is critical. Revolving credit (like credit cards) and installment loans (like your personal loan) lead to a balanced credit mix. That mix can mean a higher credit score. Paying off that personal loan early could impact the credit mix, lowering your credit score.
Paying off a loan reduces your debt, which might benefit your credit. Yet doing so could remove proof that you can manage monthly payments, which might be a problem if you need another loan.
Cash Reduction
Paying off your personal loan before it's due could provide you with less cash on hand. That $2,000 you direct toward a loan payoff means $2,000 less to add to an emergency fund. So if you end up with car trouble or a plumbing problem, you might not have the money to handle it. You might have to apply for another quick loan to pay those sudden expenses.
Additionally, paying off your loan might mean less cash for investments offering a better return. This is especially the case if your loan carries a low fixed-interest rate. Instead of an early loan payoff, that money might be better off in a high-yield bank account or CD.
Should I Pay a Loan Off Early?
The decision to pay a loan off early depends on many factors. To answer this question, it's crucial to study your loan documentation. Determine if there are extra financial costs to an immediate payoff. Also, examine your financial situation. You might find that paying a loan off early might create other financial problems down the road.
As such, there is no one-size-fits-all answer to the early loan payoff question. It's important to understand that each situation is different.
And if you need a bad credit loan or other type of financing, visit Jora Credit. Depending on your needs, Jora Credit offers quick-cash loans and longer-term installment loans. Applying takes only a few minutes, and you can receive your funding on the same day.
For more information or to apply, log on to Jora Credit with your laptop, tablet, or smartphone.