November 16, 2023 |5 min read
A personal loan is a type of installment loan where you borrow a sum of money and usually pay it back in equal amounts over a set period of time. It’s a closed-ended credit account—unlike a revolving credit account—meaning once the loan is paid in full, the account is closed.
Personal loans typically come with a fixed interest rate and repayment term. But if you find yourself with extra cash before the repayment term is over, it could be tempting to pay off the loan early. Before you do, you might want to consider how paying off a personal loan early can affect your credit scores and overall financial situation.
Key takeaways
- In most cases, you can pay off a personal loan early. Your credit score might drop, but it will typically be minor and temporary.
- Paying off an installment loan entirely can affect your credit score because of factors like your total debt, credit mix and payment history.
- The benefits to paying off a personal loan include reducing your debt-to-income (DTI) ratio and saving on interest over the course of the loan.
- Before deciding to pay off a personal loan early, it’s a good idea to check whether there’s a prepayment penalty.
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Sign up todayCan you pay off a personal loan early?
It could be possible to pay off your personal loan early—and the idea of saving money on interest doesn’t hurt.
But first, it’s worth taking some time to make sure you won’t be charged a penalty for paying off your loan ahead of time. If that’s the case, you might want to consider whether your current surplus would be better spent on higher-interest debts or put toward your savings.
There’s also your credit to consider.
Does paying off a personal loan early hurt your credit scores?
Yes, paying off a personal loan early could temporarily have a negative impact on your credit scores. But any dip in your credit scores will likely be temporary and minor. And it might be worth balancing that risk against the possible benefits of paying off your personal loan early.
You might be wondering, “Isn’t paying off debt a good thing?” And generally, it is. But credit-scoring companies look at several factors when determining your scores. Things like your credit mix, payment history and total debt can be affected by paying off a personal loan.
Benefits of paying off a personal loan early
If paying off your personal loan early is part of your debt payoff strategy, here are a few potential advantages to consider:
Reduce your debt-to-income ratio
DTI ratio measures how much debt you have compared to your income. Lenders often use your DTI ratio to decide whether or not—and at what rate—you can manage monthly payments. And paying off a personal loan could improve your DTI ratio since it reduces your amount of debt.
Save on interest
When you borrow a personal loan, you agree to an annual percentage rate (APR), which is the price you pay to borrow money. Each loan payment you make will include an additional amount of interest on top. Typically, the rate varies based on your creditworthiness. The lower your credit scores, the higher your APR might be, which is more money out of your pocket.
But say you pay off your loan one year early—that’s 12 payments, including interest, you won’t have to make. You might want to read the fine print of your loan terms for any prepayment fee and compare that to the interest you could save.
Reasons why you might not pay off a personal loan early
Paying down debt is generally a smart financial move. But there are certain situations when you might choose to continue making regular payments on a personal loan rather than pay it off early.
If you have a low interest rate
If you currently have a low interest rate on your personal loan, it could be worth first paying off other debts you may have. For example, if you have both a personal loan with a low interest rate and a credit card with a high interest rate, you may decide to put any extra money toward paying down the credit card debt.
If paying down the loan would deplete an emergency fund
Using cash to pay off a personal loan can reduce your overall monthly payment obligations. But you might reconsider if you’re using money from an emergency fund to pay down this debt. That’s because it’s a good idea to have cash readily available if an unexpected event were to occur.
If your credit scores are going to be reviewed in the near future
Paying off an installment loan entirely can result in a slight temporary dip in your credit scores. If you know your credit scores are going to be reviewed as part of an application for a mortgage or an auto loan, you might choose to postpone paying off a personal loan.
If there’s a prepayment penalty
Some lenders may charge a fee if you pay off your personal loan before the term ends. Called a prepayment penalty, it’s meant to protect the lender from losing revenue on interest.
Before paying off a personal loan early, you might want to read the agreement or ask the lender about its prepayment terms. It could also be possible to pay off the loan early without a prepayment penalty if you pay it off within certain parameters. For example, a lender might allow you to pay up to a certain percentage of the total balance annually before charging a fee.
Paying off a personal loan early in a nutshell
Paying off a personal loan early can have advantages and disadvantages. Even though your credit score may take a slight hit, paying off a loan early can lower your DTI ratio and help you save on interest.
Worried about your credit fluctuating when you pay off a personal loan early? Even if your score drops a few points, you could use other credit-building methods to repair or maintain a good credit score. Before paying off the loan, you can see how it might affect your credit score with the CreditWise Credit Score Simulator from Capital One. CreditWise from Capital One lets you monitor your credit health for free—without impacting your credit score.
Whether you choose to pay off your personal loan early or put any extra cash toward something else is up to you. By understanding the pros and cons of an early payment, you can make informed decisions with your money.
