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What to Know About Paying Off Personal Loans Early

What to Know About Paying Off Personal Loans Early
Lauren Ward
Lauren WardUpdated May 9, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
If you have a personal loan, you may wonder if you can pay it off early, and if doing so means you will pay less interest. The answer to both of those questions is yes. However, that doesn’t necessarily mean paying off your loan ahead of schedule is a good idea. Personal loans sometimes come with prepayment penalties, which could eat away at any savings in interest. And, while you might expect paying off a personal loan early to boost your credit profile, it could actually set your credit back in the short-term. Here’s everything you need to know about early payoff of a personal loan. 

Is It Possible to Pay Off Personal Loans Early?

Yes, the way most personal loans work is that you can pay them off at any time. (Many lenders will also let you do the opposite, and defer payments.) However, depending on your lender, early payoff may come with a cost. While some lenders won’t charge any fees for paying your loan off ahead of schedule, others charge a prepayment penalty.Often, the prepayment penalty will be calculated as a percentage of your outstanding loan balance. It might start out around 2% and then decline each year of the loan until it reaches zero. This set-up allows the lender to recoup any interest lost as a result of early repayment of the loan balance. The calculation method will vary from lender to lender, but any prepayment penalties would be outlined in your loan agreement.

How Paying a Personal Loan Off Early Can Affect Credit Score

Whether you took out a personal loan to pay for a wedding or to consolidate your debt, paying that loan off early shows financial responsibility. So, it stands to reason that it would have a positive impact on your credit profile. However, that’s not necessarily the case. Here’s how it works.

Possible Positive Effects

Once you pay off your personal loan, it’ll be marked as a closed account in good standing on your credit report, assuming all of your payments were made on time. It will then stay on your credit report and continue to have a positive impact on your credit for another 10 years. 

Possible Negative Effects

Paying off your personal loan is not the same as paying off your credit card in terms of your credit report. When you make a large credit card payment, it can have an immediate positive effect on your credit because it reduces your credit utilization –  the amount of available credit you're using. Paying off a personal loan, however, could actually have a negative effect on your credit score.That’s because a personal loan is an installment loan. When you pay off an installment loan, your credit report shows the account as closed. While successfully paid off loans are still part of your credit history, they don’t weigh as heavily as open accounts, which are considered a measure of how you're managing debt right now as well as in the past. Paying off your personal loan can also impact the “credit mix” aspect of your report, which accounts for 10% of your score. When you added a personal loan to your credit profile, you improved your credit mix with an installment loan. When you close the account, you do the opposite – you now have less account diversity. Paying off a personal loan early also shortens the account lifetime. “Length of credit history” accounts for 15% of your score and is calculated as the average age of all of your accounts. The longer your credit history, the better it is for your credit profile. Shortening the length of time your personal loan is open could negatively affect your average credit history length, and score. 

Is Paying Off a Personal Loan Early Cheaper?

Typically, yes, but not always. You’ll want to read your loan agreement carefully and make a few calculations to make sure that’s how things will net out. 

How Interest Is Charged

The most common method used for calculating interest on personal loans is the simple interest method (also known as the U.S. Rule method). This means interest is applied to principal only.Personal loans are typically amortized. The way amortization works is that your monthly payments stay the same over the term of the loan, and each payment is divided between interest costs and principal. Over time, the amount you pay in interest gradually goes down, and the amount you pay in principle gradually goes up. Your lender may have given you an amortization table showing each payment and how much of it will go towards interest and how much towards principal over the life of the loan. (If you don’t have one, you can use one of the many monthly loan balance calculators online.) By looking at the amortization table, you’ll be able to see how exactly much you’d save in interest by paying the loan off early. 

Early Repayment Fees

In some cases, a lender will charge 2% or so of the balance if you pay the loan off the first year. After the first year, the fee typically gets a little bit lower year to year until there is no longer a penalty for paying it off.  Other lenders charge a flat fee, and some lenders don’t charge any penalties for prepayment.If your lender charges a prepayment fee, you’ll want to do the math and compare what you’ll save in interest versus what you’ll pay in prepayment fees. 

Questions to Ask Before Paying Off a Personal Loan Early

If you're considering early payoff of a personal loan, ask yourself the following four questions to help determine if it’s in your best financial interest.

Does Paying It off Early Put You at Risk?

As you think about your financial future, remember the importance of an emergency fund. Do you have three to six month’s worth of income saved up to cover monthly and day-to-day expenses if you were to suddenly lose your job or be unable to work? If your car’s transmission were to suddenly go out, could you get it fixed without using a credit card? You don’t want to deplete your savings and then leave yourself vulnerable to running up credit card debt (which is typically more costly than a personal loan).

Is There Higher Interest Debt That Should Be Prioritized?

Counterintuitive but true: The debt product with the largest balance may not be the one that’s costing you the most money. Take a look at all of your debts and prioritize paying off the ones with the highest interest rates first. It’s more than possible that a credit card with only a few thousand dollars on it is costing you more money than a large personal loan. If this is the case, you may want to pay that off first before you tackle anything else. Paying down credit card debt will almost certainly have a positive, rather than a negative, effect on your credit profile.

Are You Trying to Improve Your Credit Score?

If you’re trying to improve your credit score to, say, apply for a mortgage, now might not be the best time to pay off your personal loan. If you’re counting on every point, you may want to keep the account open so you have continued on-time payments and a good “credit mix” on your report.

Are You Trying to Improve Your Debt-to-Income Ratio?

While your debt-to-income ratio (DTI) does not affect your credit score, many lenders (particularly mortgage and small business lenders) will strongly consider it when evaluating your loan application. The lower your DTI, the more attractive you are in the eyes of the lender. If you pay off your personal loan, your DTI will go down, since you now have smaller monthly debt payments compared with your income.Recommended: Can I Get a Personal Loan for Closing Costs? 

Pros and Cons of Paying Off a Personal Loan Early

Pros of Paying Off a Personal Loan EarlyCons of Paying Off a Personal Loan Early
Saves money on interestThere may be a prepayment penalty
Lowers your debt to income (DTI) ratioYou may not see a jump in your score
Lowers your financial burden each monthYou will have less money for emergency expenses
May improve your ability to get approved for future creditWill no longer have on-time payments on that account
Will lower your financial stress and give peace of mindMay lower some parts of your Fico score

The Takeaway

Can you pay off a personal loan early? Yes, but, but keep in mind that there may be a prepayment fee (which could lessen the cost savings), and you may not see a big jump in your credit score. In fact, you could see a temporary dip.Understanding all the costs associated with taking out a personal loan can help you compare loans and find one that fits your needs, budget, and repayment timeline at the lowest possible cost. Find out more about personal loans and compare personal loan rates with Lantern by SoFi.

Frequently Asked Questions

Is it a good idea to repay a personal loan early?
Does paying off a personal loan early hurt credit?
Is it cheaper to pay off a personal loan early?
Photo credit: iStock/VioletaStoimenova

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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