Paying off a loan early can add up to savings and freedom from debt. But do the benefits of paying off a loan before the term is up outweigh the drawbacks?
Before you make a move, weigh the pros and cons of paying off debt early.
- Pro: Paying off a loan before it matures can save you money.
- Pro: You may improve your credit profile.
- Pro: You will have more freedom from debt.
- Con: You might starve an investment to feed your debt.
- Con: You might be penalized.
Pro: Paying Off a Loan Before It Matures Can Save You Money
The main benefit of paying off your loan early is that you no longer have to fork over that money to a lender. But cutting short your loan term also has another perk.
“The sooner you pay off your debt, the less interest you pay over time,” says Madison Block, marketing communications and programs associate at the nonprofit American Consumer Credit Counseling.
In particular, paying off high-interest debt can deliver significant interest savings. Once that debt is gone, you can allocate more money to savings, Block says.
Pro: You May Improve Your Credit Profile
When you pay off a loan, your account is closed in good standing. At this point, you have eliminated the risk to your credit score posed by late or missed payments.
A paid-off loan can also lower your debt-to-income ratio, a key metric lenders use to make credit decisions. That means if you pay off an auto loan or a personal loan before you apply for a mortgage, you could qualify for better terms.
Pro: You Will Have More Freedom From Debt
The sooner you pay off your loan, the sooner you are free from the responsibility of that debt, which can give you tremendous peace of mind. “You have fewer obligations to keep you up in the middle of the night,” says Todd Christensen, education manager at Money Fit by DRS Inc., a nationwide nonprofit credit counseling agency.
If you owe a debt, the creditor has certain legal rights that can limit your financial freedom, he says. When you default on a loan backed by collateral such as your home or car, you risk losing that property.
Luckily, a growing number of people are waking up to the importance of keeping debt levels in check, says Jeff Arevalo, financial wellness expert at GreenPath Financial Wellness, a national nonprofit credit counseling agency in Farmington Hills, Michigan.
“One positive trend we’ve seen during the COVID pandemic is that people are spending less, which has, in turn, caused an increase in savings and a stronger push towards paying down credit card debt,” he says.
Con: You Might Starve an Investment to Feed Your Debt
Paying off a loan early can be a huge relief, but it shouldn’t come at the expense of larger goals, such as saving for retirement, making investments or funding college for your kids. Even more important is growing – or replenishing – an emergency savings cushion.
“We impress upon clients the importance of having emergency savings, no matter what,” Arevalo says.
If your finances are in good shape and you have enough savings to cover your expenses for six months, you can shift to aggressively paying down debt. That includes your mortgage.
“If you have a home loan and worry about what might happen during a recession – especially one involving declines in home prices – you should consider accelerating your mortgage payoff,” Arevalo says.
You may give up some gains from investing in the stock market – and miss the mortgage-interest tax deduction – but paying off your home loan early can strengthen your financial foundation.
“Consider the confidence you will have when facing a recession, knowing all you have to pay on your home is insurance and property tax,” adds Christensen, author of “Everyday Money for Everyday People.”
Con: You Might Be Penalized
Sometimes paying off a loan early comes with a cost. Lenders may charge prepayment penalty fees.
“While you might be saving on interest, getting hit with a penalty might not make it worth it in the end,” Block says.
Know the terms of your loan before you pay it off, she urges.
