People choose to pay off debt for many reasons. Some do it to increase their budget. Others pay off loans early to get control of their finances and become debt free. Some people do it in hopes of improving their credit score.
But before you start working toward paying down debt, there are some things you should know.
For starters, not all debt is created equal. Paying off debt early may affect your budget and credit in different ways, depending on the kind of debt you're paying off.
Before you adjust your budget, let’s talk about whether paying off a personal loan early is a good or bad idea?
Here are three things to consider before killing your debt:
How will paying off a loan early affect your credit score?
Maybe you’ve been told that debt is good for your credit score. Or maybe you’ve been told that debt is terrible for your credit.
So which is it?
Well, it depends.
The first thing you should know is that paying off a personal loan affects your credit much differently than paying off a credit card.
Credit unions use your credit utilization as a primary factor in determining your credit score. Your credit utilization is how much of your available credit that you are using.
When you pay off a $1,000 credit card, the account remains open after it is paid in full. So once it’s paid off, you have $1,000 worth of credit that you have access to but are not using. Your credit utilization is low. That looks very good on your credit.
But that’s not how it works with a personal loan.
If you have a $1,000 personal loan, the account will remain open as long as you are making monthly payments. So each payment you make means you are utilizing less and less of the available credit you have access to, which builds your credit.
But once your personal loan is paid off, the account is closed which doesn’t help your credit utilization.
Now, generally paying off a personal loan won’t hurt your credit significantly or for very long. So it may still be worth paying off early if you’re just trying to make room in your budget. But if boosting your credit is your main objective, you should consider keeping the account open for as long as possible and simply making regular on-time payments.
How will it affect your budget?
Having extra money each month that doesn’t go to a lender would be great for your budget. But while having a paid off loan may be a relief, how you accomplish that goal could become a burden.
For example, if your goal is simply to make double payments each month on your loan, that may not be feasible.
If paying 2X your monthly payments spreads your budget so thin that you don’t have any buffer room for emergencies, it may not be worth it.
Unexpected emergencies come up all the time. And they are never convenient. Ask yourself, if an emergency occurred, such as:
- Your car breaks down
- Your water heater goes out
- Or your child gets injured and needs medical attention
Will you have enough money set aside to pay the unexpected expense? If not, it may be best to continue making regular on-time payments and just patiently wait to make your final payment.
Alternatively, if you are eager to pay off your loan early, come up with a financial plan where you can chip away at the debt steadily.
Maybe you can’t make double payments, but there might be another solution.
For example, you could round up your payments. If your monthly payment is $240 per month, round up to $300 per month. This will help you pay off your loan quickly without straining your budget.
Is it more expensive to pay off the loan early than to make on-time payments?
Some personal loans come with a prepayment penalty. That means you may be charged a fee for paying off a loan early.
That may seem unfair, but the reason some financial companies charge this penalty is because lenders make most of their money from the interest of a loan.
If a loan is paid off early, that usually means it accrues less interest, which means the bank doesn’t make as much money from the loan.
So banks de-incentivize early payoffs by applying a prepayment penalty.
It may still be worth paying off the loan early, depending on how much the prepayment penalty will cost you. Sometimes it is only a small fee. But other times, it may cost more than just making on-time payments.
The good news is that at Midwest Finance, we never charge prepayment penalties.
Our goal is to help our customers get back on their feet. So if a customer wants to pay off their loan early, we always support them doing so.
Click here to learn more about loans at Midwest Finance.