The Pros and Cons of Paying Off a Personal Loan Early
Paying off a personal loan early is always a no-brainer, right? Not necessarily—there’s other factors you need to be aware of before making your choice.
On one hand, repaying off debt ahead of schedule can save money on interest. You might also see a credit score boost because your debt-to-income ratio will improve. But there could be drawbacks to these financial decisions. Some personal loans, for instance, come with prepayment penalties. And if you’re working on building your credit history, an early payoff might cut short a stellar record of on-time payments and even cause a temporary drop in your credit score.
So which choice is right for you? Let’s dive into the details so you can make an informed decision.
In This Article
- Advantages of Paying Off Early
- Disadvantages of Paying Off Early
- Does LendingClub Charge Prepayment Penalties?
- The Bottom Line
- Common FAQs
Reducing debt and keeping it at a manageable level are important factors in maintaining excellent credit and strengthening your financial situation. Paying off a personal loan early does all that and more.
1. You save money on interest.
The faster you can pay off a loan, the less it will cost you in interest. Because that ultimately lowers your total cost of borrowing, the potential savings can be considerable.
Here’s an example: Say you paid back $10,000 of a $30,000 personal loan that has an interest rate of 10% and three years left on your term. If you chose to pay off the remaining $20,000 balance early in a lump sum, you’d save an estimated $6,000 in interest versus paying $9,000 in interest over the full life of the loan.
2. You'll have more money in your monthly budget.
With that recurring monthly payment gone, you’ll have extra money in your budget for other needs. You’ll be able to earmark that amount for day-to-day expenses or apply it toward important financial goals like building an emergency fund, saving for retirement, or investing.
3. You'll lower your debt-to-income ratio.
Your debt-to-income ratio is the sum of your debts divided by your income and a key metric that lenders use to make borrowing decisions. By lowering your debt-to-income ratio, you may see an increase on your credit score* and qualify for more favorable loan terms and loan options in the future should you need it.
4. You gain peace of mind.
The sooner you pay off a personal loan the quicker you’re free of that debt responsibility, and having one less financial obligation can ease stress around monthly finances. But make sure paying off your personal loan early isn’t setting you up for future financial burden. Before deciding, ensure you’re able to pay your regular monthly expenses without stress and have an emergency fund set aside should you ever need it. Try not to dip into your savings or retirement accounts, either, as those accounts could save you more in the long run.
While it can save interest, put extra money in your pocket, and trim your debt load, there could be some downsides. Here are three possible impacts to consider.
1. You might owe a prepayment penalty.
Some lenders include a prepayment penalty clause in loan contracts as a way to recoup the interest they’d lose if the loan is paid off ahead of schedule. This amount is usually set as a percentage of the unpaid principal loan balance at the time of payoff.
Check your loan documents carefully and do the math before making your decision. Though you’ll save on interest, a prepayment penalty could reduce that benefit or negate it entirely, especially if your loan has a low, fixed interest rate or a shorter term.
If you anticipate paying off a personal loan early before taking out the loan, know that not all lenders include prepayment penalties in their loan terms. LendingClub, for example, doesn’t charge any prepayment fees or penalties, so you can pay off your loan early and save on interest without worrying about the drawbacks.
2. Your credit score could be affected.
When you pay off a personal loan, your credit mix and credit history changes and the results may affect your credit goals.
A personal loan appears on your credit report as an installment loan account, which includes the specific loan amount and repayment schedule. Because payment history is the biggest factor in determining your credit score, a solid record of on-time, monthly payments can be beneficial for your finances in the long term. When you pay off your personal loans early, you’re potentially losing out on months (or even years) of a positive payment history.
At the same time, the credit age of all your accounts and maintaining a well-managed mix of credit—like credit cards, student loans, or auto loan accounts, to name a few—also affects your score. Considering those key measures, paying off a personal loan early may actually cause a temporary dip in your credit score.
3. You may have smarter money options.
If your personal loan’s interest rate is lower than the rates you’re being charged on other types of debt, your money may be better spent elsewhere. Instead of paying off your personal loan early, you could focus instead on paying off higher-interest debt, like a credit card balance, which could save you more in the long run. You could also consider beefing up your retirement plan contribution at work in order to be eligible for an employer match or contributing money to a high-yield savings account.
And of course, before making changes to your monthly contributions or paying off a personal loan early, check your bank accounts and make sure you have the funds to cover both your anticipated monthly expenses and unexpected emergencies. Preparing for the future could save you a whole lot of stress.
Personal loan rates, fees, and terms vary widely by lender. That’s why it’s always important to study the details of your offer so you don’t end up paying more than necessary or more than you can afford.
At LendingClub, you can pay off your personal loan early or pay more than your contractual monthly amount at any time with no prepayment penalty or fee. Any payments you make on top of your regular monthly payment are applied toward reducing the principal balance of your loan. That flexibility allows you to reduce the amount of interest you’ll pay overall without concerns of hidden fees.
In the end, whether or not to pay off your personal loan early depends heavily on the lender. Before making a decision, consider all the potential fees and weigh the pros and cons to compare what you may gain in the short-term against your larger credit and financial goals. If you’re able to plan for paying off a personal loan early before taking out the loan, consider lenders who, like LendingClub, don’t charge penalties or fees for prepayment.
1. If I pay off a personal loan early, will I pay less interest?
Yes. By paying off your personal loans early you’re bringing an end to monthly payments, which means no more interest charges. Less interest equals more money saved.
2. What is a prepayment penalty and why do they exist?
A prepayment penalty is a fee that some lenders charge when borrowers pay off all or part of a loan before the term of the agreement ends. In effect, prepayment penalties dissuade the borrower from paying off a loan ahead of schedule, which causes the lender to miss out on interest income. The best way to avoid a prepayment penalty is to work with a lender that doesn’t charge one. At LendingClub, for example, you can make extra payments or pay off your loan in full at any time with no additional charges.
3. Will paying off my personal loan early hurt my credit score?
Paying off your personal loan early probably won’t boost your credit score because it changes your credit mix and credit history, but it doesn’t necessarily lower your credit score, either. Reducing revolving debt—like paying off your credit cards—can help improve your score by lowering your debt-to-income ratio, but in the same way keeping certain kinds of installment debt open—like a personal loan—can actually help your credit score by boosting your history of on-time payments.*
*Reducing debt and maintaining low credit balances may contribute to an improvement in your credit score, but results are not guaranteed. Individual results vary based on multiple factors, including but not limited to payment history and credit utilization.