If you own a house or a car, or have a college education, chances are good you had to take out a loan to pay for one or all of them. Managng any kind of debt can be stressful, especially if you are burdened with a high interest rate. Of course, paying a loan off early can save you money on interest and free up your cash flow sooner. But you need to take a strategic approach with early payoffs, depending on the type and terms of the loan. Here are some things to consider before you dive into becoming debt free ahead of schedule.
Should you pay off a loan early?
Before diving into the how, it’s important to consider the why. Here are some pros and cons of early loan repayment.
Pros of paying off a loan early
Save on interest costs over the life of the loan
Free up cash flow sooner
Reduce debt faster and improve credit utilization ratio
Mental freedom of being debt-free
Cons of paying off a loan early
Potential lost investment gains if money used to pay loan would earn higher returns invested elsewhere
Less flexibility in cash flow if unforeseen expenses come up
Possible prepayment penalties: Some lenders may charge a prepayment penalty of up to 2% of the loan’s outstanding balance if you pay off your loan ahead of schedule.
Could lose out on some of the credit benefits that come with making on-time monthly payments
Loss of potential tax benefits, including deducting your mortgage interest
Overall, while paying loans early makes sense for high-interest debt, it may be less advantageous for a fixed rate mortgage with a interest rate lower that the return you could get investing the money elsewhere—unless you simply have a strong aversion to debt.
What to consider when paying off different types of loans early
If you’ve decided paying off loans early aligns with your goals, let’s take a look at how the type of loan impacts your plan.
Can you pay off a mortgage early?
Most mortgages allow you to make extra principal payments with no penalty. This lets you pay down your mortgage faster. Make sure extra amounts are applied directly to principal and not just future payments. Also confirm there are no prepayment penalties.
Tips: Make biweekly payments. Round up monthly payment to nearest $100. Make one extra principal payment per year.
Pros: Build equity and save on interest faster. Shorten loan term.
Cons: Less flexibility if cash needed for other goals before paying off home. Lost potential investment returns.
Can you pay off an auto loan early?
Paying off an auto loan early can save significant money on interest, as rates are often high. There are rarely prepayment penalties. Pay extra each month, or send lump sums to be applied to the principal. Refinancing at a lower rate can further accelerate payoff.
Tips: Pay half monthly payment every two weeks to add payments. Pay lump sum with tax refund.
Pros: Own vehicle sooner. Less interest paid overall.
Cons: Less flexibility if the cash is needed for other goals first.
Can you pay off student loans early?
Federal student loans and some private lenders do not typically charge early payment fees. Paying these loans off faster can save you significantly on interest costs over time. You can send extra or make biweekly half-payments. Consider paying off the loans with the highest interest rates first.
Tips: Apply any extra payments towards principal rather than next month’s payment. Considering refinancing to a lower rate if your credit score has improved.
Pros: Pay less interest over life of loan. Free up cash flow sooner.
Cons: May lose some tax benefits or student loan forgiveness options. Weigh carefully.
Can you pay off a personal loan early?
Read the loan terms to see if prepayment penalties apply. If not, extra amounts directly to principal can help pay the loan off faster and reduce total interest paid. Pay down high-rate loans aggressively first.
Tips: Pay more than the minimum due each month. Automate payments biweekly.
Pros: Become debt free ASAP. Avoid interest costs.
Cons: Less flexibility if cash needed for other things.
The bottom line
The key is budgeting effectively and directing surplus funds specifically toward extra principal payments on high-interest debt. Revisit the loan terms first and ensure you take a strategic payoff approach. Accelerating debt payoff takes discipline, but in most cases, it saves you money and stress in the long-term.
