When Does It Make Sense to Pay Off a Personal Loan Early

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Paying off a personal loan early is a good idea under certain circumstances. Here’s when it’s worth it. 

A personal loan has a fixed repayment term, such as two years or five years or whatever you agreed upon with your lender when you first borrowed. But, you don’t necessarily have to pay off the loan on the schedule you set when you originally borrowed. You may have the option to repay your loan early by making extra payments over time or making a lump sum payment.

But, is it a good idea to repay your personal loan debt ahead of schedule? To help you decide if this makes sense for you, consider these key issues.

What is the interest rate on your personal loan compared to other debt you may have?

The first thing you need to think about is what interest rate you are paying on your personal loan versus on other debt you may have.

The Federal Reserve reports the average credit card interest rate is 20.09%, while the average personal loan rate is 11.48%. It makes no sense to pay off a personal loan early if it is at a lower rate than any other loans you have. Instead, focus on paying off your more expensive loans first and only after that is done should you switch to making extra payments on your personal loan.

Could you earn a higher rate of return by doing something else with your money?

The next big question to think about, if you have no other costlier debts, is what your ROI is on early payoff of your personal loan versus what ROI you could earn if you did something else with your money.

If you put your funds into a brokerage account and invested in an S&P 500 index fund, you could reasonably expect to earn 10% average annual returns over the long term, before inflation. If the interest rate on your personal loan is around that amount or higher, then you would get a better ROI by eliminating your interest costs. Early loan payoff would likely be the best option for your spare cash.

But if you have a personal loan at a pretty low rate — like 5% or 6% — then your net worth would likely end up higher if you kept making minimum payments on your personal loan only and put the extra money into the market instead.

How motivated are you to pay off your loan ahead of schedule?

You’ll also have to think about your motivations when you decide if you should pay off your personal loan ahead of schedule.

If you are passionate about getting rid of that debt and are willing to cut spending dramatically or increase your work hours to pay it off, then you should likely do that. You may not be willing to make these extra sacrifices to do other things with your money, and getting rid of the debt is going to leave you better off than if you spent the money instead because you weren’t as excited about other goals.

Is there a prepayment penalty?

Finally, you’ll need to consider whether your lender is going to charge you a prepayment penalty. If you incur a fee to pay off your loan early, then this could negate most or all of the interest you save. Prepayment may not be worth it.

By considering all these issues, you can decide if paying off a personal loan early by making extra payments is right for you, or whether your hard-earned funds should instead be used for other goals.

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