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Does It Make Sense to Pay off Personal Loans Early?

Christy Bieber, The Motley Fool

 

You could pay off you personal loan early, but is it a good idea? Read on to find out.

Man writing a check to pay bills.

Image source: Getty Images

Paying off debt is a financial priority for many. After all, paying interest is expensive and sending money to a creditor every month isn’t fun.

If you dream of debt freedom, you have to decide which loans to pay off first. It's obvious you should focus on paying down high-interest debt, like credit card balances or payday loans, as soon as possible. But other types of debt have more favorable terms, so early payoff may not be smart.

If you have a personal loan, for example, paying it off early might make sense for you. But it's also possible that you’d be better off keeping the loan and making minimum payments. Ask yourself these key questions to help you decide if paying off personal loans early makes sense.

What's your personal loan interest rate?

The lower your interest rate, the less sense it makes to pay off the loan early.

If you're not paying much in interest, it may not be wise to aggressively pay down your personal loan. For example, if you have a loan at 5% interest, paying it off early would give you a 5% annual return. You could probably earn a better return by investing in the stock market.

But if you have a high-interest personal loan, paying it as soon as possible becomes imperative. If you’re paying 15% interest, for example, few investments provide a higher rate of return than paying off the loan.

What other debt do you have?

Personal loans have lower interest rates than credit cards, payday loans, and car title loans. They also often have lower rates than private student loans.

If you have other debt at a higher interest rate, focus on paying that off first. Only make the minimum payments on your personal loan. Getting rid of high-interest debt will save you more money than paying off a personal loan.

On the other hand, it's usually smarter to pay your personal loan first if your only other debt is a mortgage or federal student loans. Both mortgages and federal loans come with tax breaks and lower interest rates than personal loans.

Does your personal loan have a prepayment penalty?

Some personal loans have a prepayment penalty. If you pay off the loan before it's due, you'll have to pay a fee. Prepayment penalties substantially reduce any savings that come with paying off your loan early.

Compare your prepayment penalty to what you could save by paying your loan early. You may find you’re better off continuing to pay as scheduled. If you’d save a small amount of money because of the prepayment penalty, do something else with your spare cash. You'll probably get a better return on it.

What else could you do with your money?

There’s an opportunity cost to paying off a personal loan early. For example, if you’re devoting extra money to your personal loans, you may not be able to get an employer match on your company’s 401(k). In this case, you’d be giving up a 100% return on your investment.

Likewise, you could build a business with the money that you’re using to pay off a personal loan early. Entrepreneurship can be very profitable, so you could get a higher return.

If you’re trying to pay off a personal loan early and you don’t have an emergency fund, you may need to borrow if something bad happens. Those emergency loans will probably have a higher interest rate.

Carefully consider what you’re foregoing by putting extra cash towards your personal loan. If any of those other goals might be a better use of your limited funds, consider prioritizing them.

Does paying off your personal loan early make sense for you?

There’s no one right answer to whether paying off a personal loan early makes sense. It could be a smart move if you’d otherwise waste the cash on unnecessary purchases. But it may not be the best idea if you could be paying higher-interest debt instead or you could invest the money and get a better return.

Consider your financial goals, your financial situation, and the cost of the loan before you pay off your personal loan ahead of schedule. If there are better things you can do with your money, keep paying the minimum on your personal loan. And take other steps to improve your overall financial picture. You’ll become debt-free eventually, and could find yourself in a much better financial situation by the time that happens.

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