Getting out of debt is always a worthy goal.
After all, debt can weigh you down and hold you back from reaching other personal and financial goals.
But when it comes to certain loans, is there ever a time when you might want to reconsider paying off a debt? Could there even be benefits to not closing out a loan?
The answer here is, surprisingly, yes. In certain situations, paying off a personal loan early can affect your credit – in both good and bad ways.
That said, the possible negative effect on your credit typically isn’t enough to negate the benefits of an early payoff. It all depends on your current overall credit profile.
In this article, we’ll look at how lenders set rules for paying off loans, how paying off a personal loan early can affect your credit, why your credit score drops when you pay off debt, and in what situations early debt payoff makes sense.
Can you pay off a personal loan early?
You absolutely can pay off a personal loan early. The key is to check the fine print on your loan agreement.
Some lenders charge prepayment penalties, typically up to 2% of the loan’s outstanding balance. These fees are exactly what you might think they are – a way for the lender to discourage you from pursuing early repayment.
(Why discourage this? Because the lender would collect less in interest, which is bad for them but great for you.)
These penalties also could affect you if you ever wanted to refinance to a lower interest rate. To do so, you would have to pay off your current loan with the higher interest rate, which would trigger the prepayment penalty before you could switch to the low-interest option.
Before you sign anything, read your loan agreement and Truth in Lending disclosures to see if your contract includes a penalty for paying off your loan balance early. You could possibly negotiate that penalty with your lender.
While you’re looking through those documents, it’s also a good idea to verify that everything matches what you discussed with the lender.
Pay attention to the term of the loan, monthly payments, interest rate, APR, and prepayment penalty if there is one. If something doesn’t match, make sure to get new paperwork created. These items are negotiable as well.
How paying off loans affects your credit
Several factors go into determining your credit score and creditworthiness.
The main three credit bureaus – Equifax, Experian, and TransUnion – compile and maintain your credit report using financial information such as your mortgage debt, credit cards, and auto and personal loan debt.
That information is used to determine your credit score and how dependable you are paying on time. Most of their formulas include these factors used by FICO:
Payment history (35%): If you have a history of missing or late payments, your score will be negatively affected. On the other hand, a record of on-time payments helps you build good credit.
Credit utilization ratio (30%): Your credit utilization ratio is your total revolving credit divided by the total credit you have available. Lenders like to see this number at 30% or lower. They’ll also consider your debt-to-income (DTI) ratio, which is the total amount of debt payments you make monthly divided by your total monthly income. The lower your DTI, the better. Paying off debt helps your DTI but lowers your credit utilization, which could ding your credit score.
Credit history (15%): A longer credit history with multiple open accounts has more of a positive effect on your overall score. When you do choose to close an account, you can likely expect a temporary ding to your credit score. Experian says this would occur about a month after closing the account and last only a few months.
New credit (10%): Opening a new line of credit will likely help your score because it will add to the amount of credit you have available.
Credit mix (10%): Having different types of credit lines – mortgages, personal and auto loans, credit cards – has a positive effect on your overall credit. So paying off a personal loan would reduce your overall credit mix, which could have a negative impact on your score.
Why your credit score drops (temporarily) when you pay off debt
When the factors listed above change, your credit score might dip, but only temporarily.
For example, if you pay off an installment loan and that account gets closed, your credit utilization ratio changes because you would have reduced your total available credit.
Think of this in terms of credit cards. This is a form of revolving debt, which means there is no set term and you can always borrow money again after it’s paid back.
So if you have a $10,000 credit limit and a $5,000 balance on the card, your credit utilization ratio is 50%. If you were to pay off the balance and close the account, your score would be negatively affected because your credit utilization ratio would drop, as well as your active credit history and the diversity in your credit mix.
If you were to keep that account open, you would have reduced the amount of available credit you’re using, which could help your credit score.
Experian says any negative effect on your credit score from paying off a loan or credit card account is only temporary, usually improving within one or two months after paying off the debt.
When it makes sense to pay off a loan early
The greatest advantage to paying off a loan amount early is simply saving money. With the loan out of the way, you’ll no longer accrue interest, which compounds your overall debt. Paying off a loan also reduces your debt-to-income ratio, making you a more attractive borrower for future potential loans.
Before paying off a loan, make sure you know how much you have in your savings account — including your emergency fund. No matter your financial situation, you should have three to six months’ worth of expenses saved up in case of an emergency or major life change. Have that fund in place before aggressively attacking your debt.
Then, anytime you receive a decent sum of money, whether unexpected or not, consider putting that money toward your debt. These situations might include a tax refund, an inheritance or a raise.
Even if you can’t pay off everything in a lump sum, making extra payments will put a dent in your overall debt and improve your financial situation faster. You might choose to use the debt snowball method where you list your debts from smallest to largest and pay them in that order. Attack that smallest debt first, then move on to each one until you’re out of debt.
From an interest standpoint, paying off the higher interest rate loans first – and working down to the loans with the lowest rates – is another approach.
