If you have a little extra money and you’re considering repaying your personal loan early, it can reduce the amount you pay in interest.
But paying off a loan early can have consequences. Sometimes personal loans come with prepayment penalties.
While repaying a loan early won’t ruin your credit it can have an impact on your score.
What effect does repaying a loan early have on your credit?
Maintaining your monthly payments on a loan is good for your credit profile. However, you’d be wrong to think that paying early would be better than maintaining your agreed payment schedule.
Clearing a personal loan doesn’t have the same impact as paying off a credit card as far as your credit profile goes. When you make a larger repayment on your credit card you are reducing your credit utilisation. Typically, the lower your credit utilisation, the better.
However, when you pay off your personal loan that credit account is closed. Open accounts have a greater impact on your credit score than closed ones. This is because open accounts are seen as a measure of how you are managing your debt in the present as well as the past. Successful repayments towards your loan are still a part of your credit history, but they don’t have the same impact on your score.
Closing your personal loan account can also reduce the diversity of your credit mix. A diverse credit mix is also a factor in determining your creditworthiness and lenders like to see diversity.
Paying your personal loan off early will also reflect a shorter account relationship. Longer credit history is a factor in determining your credit score so it’s worth keeping in mind.
Find out more about [what affects your credit score](What affects your credit score?).
What should you consider before paying off your loan?
If you’re wondering whether or not paying it off early is a good idea, only you can figure that out. It can reduce the amount of interest you pay, as well as reduce your monthly debt load. But it can also be somewhat damaging to your credit score, if only temporary and minor.
If you are thinking about paying off your personal loan early you should consider the following:
Do you need your credit score to be at its best?
While the damage to your score from repaying your personal loan early would only be minor and temporary, sometimes every point counts.
For example, if you’re applying for a mortgage you want your credit score to be at it’s best so you can get the best rate. If repaying a loan early would damage your score, even slightly, it might be better to hold off until after your application has been approved.
Is your debt-to-income ratio a factor?
On the other hand, your debt-to-income ratio (DTI) can be critical to being approved for a loan. While a DTI doesn’t affect your credit score, lenders do consider it a key factor when reviewing your application.
If repaying your personal loan early significantly reduces your DTI, you might find that has more of a positive impact than your credit score being a few points higher.
Do you have credit card debt?
Credit card debt typically carries a much higher interest rate than a personal loan. Financially you might be better off using the money you are considering putting towards clearing your loan toward clearing your credit card.
Putting the money towards clearing your credit card is also more likely to have a positive effect on your credit score.
Are there other risks?
Repaying a personal loan early can save you money on interest. But using your savings to clear it could also reduce your ability to cope in a financial emergency if there is one.
If you have significant savings and repaying a loan early doesn’t clear out your savings then this may be less of a concern. However, if this isn’t the case for you, you need to consider whether or not you’re putting your finances at risk by using your savings to repay your loan early.
Are there clear benefits to repaying your loan early?
The only way to determine if clearing your personal loan early is worthwhile is to consider the benefits of doing it. So you need to ask yourself why you’re doing it.
In the end, it comes down to your personal circumstances...
...only you can determine how repaying a personal loan early will affect your finances and overall well-being.
Tags: Loans, Your Money