Paying off a personal loan early? Beware of these things
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Tara Mastroeni is an expert on personal finance, real estate, and mortgages. Her work has been featured by Forbes, Fox Business, Business Insider, and Yahoo News.
Updated October 16, 2024, 2:47 AM EDT
If you're almost done paying off your personal loan, it may be tempting to do everything you can to pay it off early. After all, who doesn't want to have one less monthly payment to worry about? However, believe it or not, paying off your personal loan debt before it’s due may not always be the smartest financial move you can make.
With that in mind, below are five things to keep in mind if you're considering repaying your personal loan early. Then decide if paying off your debt in advance is the right choice.
Monthly expenses
Before you can decide whether it makes sense to pay off your personal loan, you need to consider your other monthly expenses. Put simply, it does not make sense to repay your personal loan if doing so gets in the way of keeping up with your living expenses. Your monthly expenses (any mortgages or housing payments, utility bills, and grocery bills) should always be your first priority.
The same goes for any other recurring debts, like a student loan or car payment. It's absolutely crucial you keep up with your monthly payments for these items. Not only will doing so help keep extra fees from accruing, but it will also ensure your credit history stays in good shape.
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Emergency savings account
Along with taking care of your monthly expenses, building an emergency savings account is also something that you should prioritize over paying off your loan early. As the name suggests, an emergency savings account is meant to help you cover unexpected expenses like medical bills or car trouble.
Conventional wisdom states that you should aim to have three to six months’ worth of expenses in an emergency fund at all times. If you don't have that much in place yet, that's okay, but you should take the time to build up your fund before tackling other financial goals.
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Prepayment fees
As you might be able to guess from the name, prepayment fees are fees that you’ll be charged by the lender if you choose to pay off your loan early. While these fees are, admittedly, less common these days, they still exist. They are there to ensure that the lender will still make money off of your loan, even if you skip interest payments by repaying the loan early.
Your first step should be to read over the loan terms to make sure you don't have a prepayment fee. If you do, take the time to calculate how much you'll save by paying off your personal loan early and compare that to the amount of the fee. If your interest rate is relatively low and the fee is high, it may be worth it to just wait to pay off your loan and to keep making your monthly payments normally.
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Retirement funds
No matter how old you are, saving for retirement is crucial. Whenever possible, your goal should be to grow your retirement accounts, not to take away from them. With that said, it's not the best idea to take money out of your retirement accounts to pay off a loan early. In fact, doing so could have some costly tax consequences.
Depending on the type of retirement account you have, there might be a penalty for withdrawing from your account early. The early withdrawal penalty is often 10%, which is charged on top of paying regular income tax on any amount that you’ve taken from your account.
If you're considering going this route, you’ll want to calculate how much you'll spend on penalties and compare that to how much you'll save by paying the loan off early. It will probably make more sense to just keep making the regular payments on your loan.
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Interest rate
Lastly, before paying off your personal loan early, you’ll want to compare its interest rate to the ones you're paying on your other debts. Generally, some other types of debt, like credit card debt, come with higher interest rates, which means it makes more sense to pay down those first. By working to pay off your debt with the highest interest rate, you'll save more money on interest charges over time.
That said, if you have an unsecured loan and a less-than-perfect credit score, there is a chance that the interest rate you’re being charged on your personal loan could be relatively high. In that case, it likely makes sense to use any extra income to pay down your personal loan as quickly as possible.
Interest rates on personal loans are dropping right now, thanks to the Federal Reserve's rate cuts in the spring. So, it's actually a great time to consider taking out a personal loan if you're looking for some extra cash. Credible can help you compare rates to find the best deals.