Key takeaways
- Prioritize paying down high-interest debts first to save money in the long term.
- It’s important to continue to save to earn compounding interest.
- Debt repayment strategies can help you get out of debt faster and save on interest.
The pros and cons of paying off debt early are important to consider before you dive headfirst into accelerating your repayment plan. While eliminating debts ahead of schedule can seem like the obvious choice, it’s not always that simple. Yes, you may be able to save on interest payments, lower your monthly bills, and have a weight lifted, but you may miss out on building an emergency fund or saving for retirement.
Let’s explore the benefits and potential downsides of early debt repayment to help you decide if it’s the right choice.
Jump to:
- Can you pay off a loan early, and should you?
- When should you pay off debt before saving money?
- Are there other financial priorities you should consider?
- Does paying off a loan early hurt credit?
- Pros of paying off debt early
- Cons of paying off debt early
- Can I save money and pay off my debts at the same time?
- Should I get a loan to pay off debt?
- Why do you need a debt repayment strategy?
- What are some debt repayment strategies?
- Bottom line
Can you pay off a loan early, and should you?
Most lenders let you pay off your loan early. The question then is, should you?
Deciding whether to pay off your loan early is a significant financial decision that requires careful consideration. While the idea of not owing any money is appealing, there are disadvantages to paying off debt. It’s essential to evaluate your overall financial situation and goals.
Less stress, improved health
Having less debt can significantly lower stress levels, contributing to improved mental and physical health. The peace of mind that comes with eliminating a financial burden can be a powerful motivator, even if it means sacrificing potential earnings from other investments.
Do you have other high-interest debts?
Before focusing on paying off a specific loan early, consider whether you have high-interest debts, such as credit card debt. Debts with high interest rates can grow quickly. They may cost you more in the long run than the interest saved by paying off low-interest personal loans early.
If you’re juggling multiple accounts, it may be wiser to use your extra funds to pay off higher-interest obligations first. A payoff calculator can help you compare different scenarios and identify the most cost-effective strategy for becoming debt-free.
Is there a penalty for paying off a personal loan early?
Some lenders charge a prepayment penalty when you settle your loan before the agreed term. The penalty is because they make most of their money off interest. If you pay the loan off before the agreed-upon date, they lose money. By charging a fee, they make up for the interest they would have earned.
Find out if your loan has a prepayment penalty, as it could cancel out any savings you’d gain by settling the loan sooner. Many lenders have stopped charging this fee. It’s likely that you can pay it off early at no extra cost.
What type of debt do you have?
There is a big difference between paying off a student loan early vs. a payday loan. Payday loans have notoriously high interest rates, and so should be paid off as soon as possible. Other loans, like student loans, personal loans, and mortgages, tend to have lower interest rates, so paying them off early is less of a concern.
Credit cards tend to have high interest rates. Paying off your credit card balance in full is usually a very good idea. Then, settle other debts.
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Freedom to pursue other life goals
Paying off a loan early can give you the financial freedom to pursue other goals, such as buying a home, starting a business, or traveling.
Does paying off the loan align with your financial goals?
Early repayment might make sense if your primary goal is not to owe money. However, if you’re focused on building wealth or saving for retirement, you might find that investing extra money elsewhere yields a better return.
Could you earn more money elsewhere?
One critical consideration is whether you could earn a higher return by investing your own extra cash in funds rather than paying off your loan early. For instance, if your loan has a low-interest rate, you might benefit more from investing in the stock market, your 401 (k), or other opportunities that offer a higher rate of return. Carefully weigh the potential earnings against the interest saved by paying off the loan early. A payoff calculator can help you estimate the savings from early repayment and compare them to potential investment returns.
When should you pay off debt before saving money?
Pay off high-interest debt like credit cards and payday loans before focusing your attention on saving money. This is because high interest rates can quickly negate any savings you might earn.
For instance, the average credit card interest rate is 24.33% according to LendingTree and the interest compounds daily. That means your interest is calculated and added to your balance each day, not just at the end of the billing cycle. The more frequently interest is compounded, the faster your debt grows.
Are there other financial priorities you should consider?
Before you start aggressively paying off your debt, look at your savings. Ramsey Solutions promotes aiming for a $1,000 emergency fund before tackling your debt, even high-interest debt.
Additionally, if you have upcoming large expenses, such as a major home repair or medical bills, it might be wise to allocate cash toward these needs to avoid borrowing later.
Don’t forget about your retirement. Saving for retirement is essential to your financial health. You need to find a way to strike a balance between paying off debt and saving money for later in life.
Emergency fund
Building an emergency fund is crucial. If you don’t have one, prioritize building a modest one first. Put any extra cash into a high-yield savings account and set it aside for a rainy day. A high-yield savings account pays interest to you instead of the other way around. Not only will you save money, but you’ll be earning money too.
Ideally, you should have at least three to six months’ worth of living expenses saved. If that’s too much, start with $1,000 or even $500. Then, next time you need emergency cash immediately, you can tap into your savings rather than having to borrow.
Balancing debt payoff with savings is critical. Paying off debt is important, but a safety net helps to keep you out of debt in the future.
Does paying off a loan early hurt credit?
Paying off a loan early can hurt your credit, but that doesn’t mean you shouldn’t do it. If you only have one loan and the rest of your accounts are credit cards, then paying off the loan will lower your credit mix. Closing an old account will also shorten the length of your credit history, potentially explaining why your credit score dropped. While it’s frustrating that your score dropped, being out of debt is much better for your credit overall.
The pros and cons of paying off debt early
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Pay less interest
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Reduce debt-to-income ratio
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Relieve financial stress
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Free up cash
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Improve your credit score
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One less monthly payment
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Less money in the short term
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May incur prepayment penalties
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Can reduce your credit mix
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May affect the average age of your credit accounts
Pros of paying off debt early
Pay less interest
Paying off debt early means you spend less money on interest over time. This can result in significant savings, especially with loans and credit cards with high interest rates. By eliminating the debt faster, you reduce the total cost of borrowing and keep more of your money in the long run.
Reduce debt-to-income ratio
Eliminating debt lowers your debt-to-income (DTI) ratio, which is a key factor lenders consider when approving loans or credit. A lower DTI can make you a more attractive borrower, improve your chances of qualifying for better terms, and even positively influence your credit score over time.
Free up cash
Once a debt is paid off, the money you were putting toward monthly payments becomes available for other financial goals. Whether you want to build an emergency fund, invest, or save for a big purchase, paying off debt early gives you greater control over your income and more flexibility in your budget.
Cons of paying off debt early
Less money in the short term
Paying off debt ahead of schedule means committing extra funds now that could be used elsewhere. This might strain your monthly budget or reduce your ability to handle unexpected expenses. While the long-term benefits are clear, the short-term trade-off is less cash on hand for day-to-day needs or other financial opportunities.
May incur prepayment penalties
Some lenders charge prepayment penalties if you repay a loan before the agreed term. These fees are designed to compensate for lost interest income. Before making an early payoff, check your loan agreement. Otherwise, you could spend more than you save by settling the debt ahead of schedule.
Can reduce your credit mix
Paying off a loan may adversely impact your credit score by decreasing your credit mix. Credit scoring models value a healthy combination of revolving (like credit cards) and installment (like loans) accounts. Closing out an installment loan may reduce this diversity, potentially causing a slight dip in your credit score, even though you acted responsibly.
Can I save money and pay off my debts at the same time?
You can save money and pay off debts simultaneously. For many debtors, this balanced approach is often the most effective strategy for long-term financial health.
Making extra payments: a balanced approach
One way to achieve this balance is by making extra payments toward your outstanding balances while still setting aside a portion of your income for savings. For instance, you might allocate 5% of your income to a high-interest savings account and 15% to debt payments. This strategy allows you to reduce the total interest paid over the life of your loan while still growing your savings.
A debt management plan can get you out of debt for less!
Should I get a loan to pay off debt?
Debt consolidation loans are popular and be useful, but they are not for everyone or every situation. You have to make sure that you pay off the loan and don’t just move debt around.
Using a loan to pay off debt is a good idea if you can secure a loan with a low interest rate, few fees, and a reasonable repayment term. Then the loan can save you money on interest, not extend the time you are in debt, and simplify your finances.
Do not take out a debt consolidation loan with a higher APR, many fees, or an extended repayment term. In this case, the loan will cost you money and keep you in debt longer.
Why do you need a debt repayment strategy?
A debt repayment strategy helps you effectively and efficiently pay off your debt. Without a clear plan, it’s easy to become overwhelmed by multiple payments, high-interest rates, and the sheer burden of debt. A well-thought-out strategy helps you prioritize which debts to pay off first, provides structure and discipline, and makes it easier to stay on track.
What are some debt repayment strategies?
There are plenty of strategies for how to get out of debt. The right one depends on how much you owe, your interest rates, and your financial situation. Here are some of the most common methods to consider, each with its advantages and potential drawbacks.
The snowball method
The snowball method prioritizes paying off your smallest debts first without considering the interest rate. Make minimum payments on all accounts, focusing any extra funds on paying off the smallest balance. Once you have that debt paid, you move on to the next smallest balance. The snowball method can be highly motivating since it gives you quick wins and builds momentum.
The avalanche method
The avalanche method aims to tackle the debts with the highest interest rates first. You make minimum payments on all accounts but direct any extra funds toward the balance with the highest interest rate. As you pay down your debts that rack up the most interest, you save money. The avalanche method is the most cost-effective option, but it can take longer to see a win.
Debt management plans
Debt management plans (DMPs) are arranged through nonprofit credit counseling agencies. The agencies work with your creditors to reduce interest rates, waive fees, and establish affordable monthly payments. DMPs do not reduce the principal amount owed but can make repayment more affordable by lowering interest rates and extending repayment terms. This strategy is good if you need assistance, can afford monthly payments, and want to avoid more drastic measures like bankruptcy.
Consolidate your debt
Debt consolidation merges multiple debts into one loan or a balance transfer credit card. You end up with one monthly bill, simplifying your finances. The new loan or card should have a lower interest rate and more manageable payment terms.
Is debt consolidation a good idea for your specific situation? While it can provide immediate relief, it may extend the repayment period and increase the amount of interest paid over time.
You will also need good credit to secure a low-interest loan or balance transfer card. If your credit score isn’t up to par, look into credit counseling. Some credit counseling agencies offer payday loan consolidation. They can negotiate lower rates and set up a structured repayment plan to help you pay off debt efficiently.
Debt settlement
Debt settlement involves negotiating with your creditors to pay your outstanding balances in a lump sum that is less than the full amount you owe. While this can reduce the total owed, it will negatively impact your credit score, has tax implications, and not all creditors will agree to a settlement. Debt settlement can be a viable option if you’re struggling to make even minimum payments and have overwhelming bills, but it should be approached cautiously.
Bankruptcy
Bankruptcy is a legal process that can provide relief if you are unable to pay all you owe. There’s no legal threshold for how much debt you need to file bankruptcy. The decision comes down to whether you can realistically repay your debts.
There are two types of bankruptcies for individuals: Chapter 7 and Chapter 13. Chapter 7 involves liquidating assets to pay off creditors. Chapter 13 restructures debts into a manageable repayment plan. Which one you qualify for depends mainly on your income.
While bankruptcy can offer a fresh start, it has long-lasting consequences on your credit and financial future. It should be considered only as a last resort.
Frequently asked questions
1. Does paying off loan early reduce interest?
Paying off a loan early will reduce the interest that you pay. Check that your lender does not charge a prepayment penalty to make up for the interest lost.
2. Do you pay less interest if you pay off a loan early?
You will pay less interest if you pay your loan early. This is because you are paying down the principal faster, reducing the amount of outstanding debt on which the interest is calculated.
3. Why does your credit score go down when you pay off a loan?
If you’ve ever asked, “Why did my credit score drop after paying off debt?” you’re not alone. This unexpected dip can stem from changes to your account mix and length of credit history. If the loan was your only installment account, then paying it off will lessen the diversity of your accounts. Lenders prefer it if you have both loans and credit cards. Paying off an older account can decrease the average age of your accounts, again hurting your score.
4. What happens when you pay off all your debt?
You gain more financial security and money every month, allowing you to save, invest, or spend more freely. Your credit score may also improve as your debt-to-income ratio decreases.
3. Should you pay off debt or keep money in savings?
Whether you should save or pay off debt depends on your financial situation. If you have high-interest credit card debt, paying it off first can save you more in the long run. At the same time, you need to build up an emergency fund. Having a savings cushion will help prevent you from accumulating more debt in an emergency. Balancing debt payoff with saving is often the most prudent approach.
Bottom line
Deciding whether to pay off debt early or focus on savings is a deeply personal decision. For some debtors, the peace of mind and financial freedom of debt payment outweigh other considerations. For others, investing, saving, or pursuing other financial goals may be more beneficial before aggressively tackling debt.
A good financial strategy is establishing an emergency fund with at least $1,000 and then aggressively paying down high-interest debt. Focus your efforts on credit cards or personal loans with interest rates over a 10% APR. Don’t worry as much about low-interest debt like mortgages, student loans, or home equity loans. Once you’ve paid off your high-interest debt, then focus on building a safety net with at least three to six months of living expenses.
A combined approach to saving and paying off debt will leave you better off financially. You will not be trapped by high monthly payments and will have a safety net to fall back on.