Can you pay off a loan early? It depends on the terms and conditions of the loan you signed up for. Should you pay off the loan early? It depends on your financial situation. We’ll provide a few rules to determine when you can and should pay off your loan early.
Can You Pay Off a Loan Early?
This is actually something that should have been addressed in the fine print of the contract you agreed to when you signed up for the loan. Some loans are closed. This may mean you aren’t allowed to make early payments at all. More often than not, you can make early payments, but the amount you can pay extra toward the loan balance is limited. In other cases, they limit when you can make extra principal payments. That’s actually common in the case of mortgages, such as limiting you to an extra principal payment at the end of the calendar year.
Lenders generally charge a prepayment penalty. The prepayment penalty amount should be spelled out in the contract. It may even be prominently shown on the website below where you have the option to pay extra toward the loan balance. It is sometimes next to an alternative like “make your next payment early”. This alternative doesn’t pay off the loan faster, unless you’re toward the end of the loan. Instead, it makes it look like you’re paying things down while the lender guarantees that they’re going to receive the next payment on time.
What are the key takeaways from this? Know what the lender will charge you, if anything, if you make an extra principal payment. Know what you’re doing when you send in extra money so that it doesn’t become an early payment for the next months without actually accelerating the retirement of the loan.
Should You Pay the Loan Off Early?
Suppose your loan will allow you to make principal payments. If there is a prepayment penalty, you’ll want to run the numbers. How much will you have to pay as a penalty if you pay additional toward the loan? And how does that compare to the interest you’ll pay on that amount? Prepayment penalties are often set to be comparable to the lost interest income, but you may come out ahead if you’re paying the loan down significantly. If you’re close to the end of the loan, you could avoid the prepayment penalties by paying the next several months’ payments in advance. This is like sending in five 500-dollar car payments when there are five months left on the loan. They’ll accept it, because they aren’t losing the interest on the car loan. But you’re eliminating the debt, once they accept these payments.
Another factor to consider is the interest rate on the debt you want to pay off early versus other debt that you hold. There’s little benefit to paying off a loan with ten percent interest annually if you have a credit card accruing thirty percent interest. And you shouldn’t be paying down a credit card balance if you’re stuck with an insane 300 percent or greater APR on a payday loan or title loan.
Yet another thing to consider before you pay off personal loan early is what you may be able to do with the cash. We’re not talking about spending the money on things that you want. Instead, we’re talking about other uses of the same cash. Could you get current on your utility bills, eliminating late fees that are equivalent to 30 percent interest? Could you add more margin to your bank account, so that you aren’t hit with overdraft fees so often? And you could save it.
Why would you want to save money instead of paying down debt? Setting up a savings account that you only touch in emergencies could help you break the cycle of debt. Studies show that half of adults can’t pay a 500-dollar expense they weren’t planning on, whether it is a car repair or medical bill. More than half couldn’t pay an unexpected 2000-dollar expense without borrowing money. If you have 500 dollars saved, you can use the savings to pay for a several hundred-dollar expense without having to take out a high interest loan. If you have 2000 dollars saved, you can pay for a large, unexpected expense. Note that this means you have to say no to the impulse to buy electronics or go on a trip when the opportunity arises.
Where Is the Money Coming From?
It is often worthwhile to take out a lower interest loan to pay off a higher interest loan. Use a cash advance on a credit card to get out from under an oppressive payday loan. Apply for an unsecured loan to free yourself from the title loan that could rob you of your ability to drive to work if you’re late with the payment, while you’re still stuck with the car note.
Run the numbers before you do what some financial gurus call borrowing against yourself. Don’t borrow against your 401K unless you’re sure you’ll stay at your job. If you get laid off or quit, you have to pay that loan back with interest or else pay taxes on the remaining loan balance. That could equal half the amount you borrowed. If you’re deeply in debt, pause the retirement account contributions so you can stop sinking deeper into debt. And take a look at your tax withholding. Too many people over-pay their taxes every month and then blow their tax refund like they won the lottery, while they’re going deeper into debt every year. If you do get a tax refund, put 500 or 1000 dollars in an emergency fund and use the rest to pay off debt.
Borrowing against an insurance policy is wasteful in its own right. You’re paying several hundred dollars a month for over-priced life insurance for the opportunity to borrow a few thousand dollars against the cash balance. Most people would be better off switching to a cheaper term life insurance policy and using the extra 100 to 250 dollars a month to pay down debt. Try to sell items you aren’t using rather than borrowing against them.