What to Know About Paying A Personal Loan Off Early

2020-11-22T19:58:27-08:00November 20th, 2020|Personal Loans|

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What to Know About Paying A Personal Loan Off Early

Nobody likes feeling debt hanging over them. Monthly payments can be painful to make month after month, especially when it feels like we could be using that money for something else more fun or interesting. 

Now that you are in a better position for paying off bills, you might be looking at that personal loan as your first target. Paying down your debt is absolutely a good thing. But before you pay off your personal loan early, be mindful of a few things you need to consider.

Interest Rates

Before you start throwing extra money at your personal loan, take a look at interest rates. Personal loans work differently than credit cards. A credit card has a very high interest rate, and that interest is charged over and over again, which is what makes those cards such a challenge to pay down. 

Personal loans have a set interest rate that is likely much lower than your personal loan. That interest is already included in the monthly payments for your loan, so your payments don’t change, and you are likely paying far less in interest with a personal loan than a credit card. 

Granted, paying down the principal of a personal loan quickly will save you money in interest payments, it is likely less savings than paying down a high interest credit card. If you have both a personal loan and credit card debt, it makes far more sense to pay down the credit card debt first – it’s likely costing you quite a bit more.

Prepayment Fees

Speaking of costing you more, personal loans might have a prepayment fee or prepayment penalty. This would be disclosed in the paperwork and agreement you signed when you took out the loan initially. A prepayment fee is money you must pay if you pay off your loan early. It’s designed to discourage you from paying down debt too quickly, which would make your debt a bit less profitable for the bank. 

Paying down the principal of a personal loan quickly means the bank will miss out on some of the interest you would have paid over the life of the loan. That leads to less profit for them and more savings for you. 

To discourage you form paying off a loan early, they charge you a fee. So long as that fee is less than you would have paid in interest, you’re still coming out ahead. But if the fee is higher than the savings, it makes more sense to use the extra money in your monthly budget to pay down something else first and wait this one out. 

Emergency Savings

Having extra money on hand makes it very tempting to immediately start paying things off. And that’s a great impulse to have. Too much debt can be a dangerous thing. But what is even more dangerous is leaving yourself without any safety net. Before you start throwing extra money at your debt payments, including your personal loan, consider your safety net, or emergency savings.

Do you have enough cash on hand to cover an emergency if one should arise? Can you cover a trip to the emergency room? An emergency plumber? A quick car repair? You need a healthy emergency fund of readily accessible cash to buy you some breathing room on day to day adventures. It’s never a question of if an emergency will happen, it’s a question of when. 

So, before you start throwing every extra dollar at your debt, throw a few into a savings account first to be sure you have cash on hand. Once you’ve built up a bit of a nest egg, perhaps $1,000 – $2,000, which is enough to cover most typical emergencies, you’re ready. Buy yourself some peace of mind, and then buy your way out of debt.

Retirement

It’s tempting to look to your retirement savings as a pathway out of debt. A large chunk of money is sitting in an account while you struggle to pay your minimum payments and have a personal loan waiting to be paid off. Don’t let this temptation sway you to make a poor financial decision.

You will need those retirement savings in the future. There are penalties for withdrawing funds from your retirement savings that you pay at the time and that you’ll pay again over and over when you are ready to retire. Retirement accounts grow exponentially with new investments. The more money in the account, the more it will continue to grow. 

Your budget might be painful right now, but don’t decimate your future as well by pulling money out of retirement to tackle your personal loan. Leave retirement accounts – and retirement savings – alone and focus instead on finding ways to trim your spending or boost your side gig income to help pay off that personal loan more quickly. 

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