You want to get to debt-free status as soon as possible, and all that’s standing in your way is a $5,000 loan with a 2.5% interest rate.
Paying it off and freeing up those monthly interest payments for other purposes is naturally appealing. What should you do?
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While paying off a loan early sounds attractive, there may be some downsides. Understanding your loan terms and potential consequences of an early payoff is key to making the right decision.
When it makes sense to pay loans off early
One of the main reasons borrowers pay off loans early is to save money, particularly on high-interest loans.
You can use the money you save in interest payments to pad your emergency fund, save for a down payment, build a retirement nest egg or even increase your budget for entertainment and hobbies.
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Paying off your loan early could boost your creditworthiness. Lenders look at a metric called the debt-to-income (DTI) ratio when assessing your eligibility for a loan.
The DTI is the percentage of your gross income that goes to debt payments. A low DTI suggests you can manage loan payments, meaning lenders will likelier approve you for a mortgage at a competitive rate.
Why you may want to hold off
However, just because you can pay off a loan early doesn’t mean you should. There are other ways you can use your money to improve your financial situation.
One potential issue is that some lenders charge a prepayment penalty when borrowers pay off loans early. Lenders do so to recoup any losses incurred from the interest they could have earned on your loan. That penalty could negate what you save in interest payments.
Ironically, paying off your loan early could negatively impact your credit score.
Yes, it sounds strange, but an early prepayment could affect the length of your credit history, credit utilization and credit mix. All these factors affect your credit score.
You might be better off using your money to build an emergency fund that could help you get by if you’re laid off or pay for an unexpected home repair or medical bill.
In fact, if you find yourself in such a situation without an emergency fund, you might need to take out a loan at a higher rate than 2.5%, meaning even more of your hard-earned money would go towards interest payments.
One of the best options? Investing money to earn you a higher rate of return than the money you save by paying off the loan.
Consider talking to a financial advisor to weigh your options.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
