If you pay off a loan early

Personal loans are a type of installment loan where you borrow a sum of money and pay it back over a set period of time. They’re closed-ended credit accounts—unlike revolving credit accounts—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.

Can You Pay Off a Personal Loan Early?

Yes, 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?

In short, yes—paying off a personal loan early could temporarily have a negative impact on your credit scores.

You might be thinking, “Isn’t paying off debt a good thing?” And generally, it is. But credit reporting agencies look at several factors when determining your scores. Things like your credit mix, payment history and credit utilization can be impacted by paying off a personal loan.

• Credit mix: Your credit mix is made up of the different types of loans you have. It might include credit cards, student loans, mortgages and personal loans. A well-maintained credit mix shows that you are a responsible credit user—which can boost your credit scores. However, when you pay off a personal loan early, you might eliminate that loan type from your credit mix. This could reduce the diversity of your loans and lower your scores.
• Payment history: On the other hand, your payment history shows information about your credit account payments, like how many accounts you’ve paid on time and how long any late payments went unpaid. A personal loan can actually improve your credit scores by building up a positive payment history—if you pay on time. But paying off the loan early means fewer chances to make those on-time, in-full payments.
• Credit utilization: Finally, the amount of available credit you’re using—also called credit utilization—can affect your credit scores. Say your credit cards and other loans have high outstanding balances, but your personal loan has a lower balance since you’ve been diligently making payments. This could equal out to an acceptably low credit utilization ratio.

However, 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.

Additional Considerations About Paying Off a Personal Loan Early

If paying off your personal loan early is top of mind, it can still be part of your debt payoff strategy. Here are a few other outcomes to consider.

Reduce Your Debt-to-Income Ratio

Debt-to-income (DTI) ratio measures how much debt you have compared to your income. Lenders often use your debt-to-income 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.

While a good ratio varies by situation, the Consumer Financial Protection Bureau (CFPB) recommends that homeowners keep their DTI ratio at 36% or less. And for renters, the CFPB recommends a DTI ratio of 15%-20% or less.

You can calculate your debt-to-income ratio by adding up your monthly obligations—like mortgage, credit card payments and, in this case, personal loan payments—and dividing by your gross monthly income. So when you pay off a personal loan, you remove it from the top of the equation. Your lowered DTI ratio could give you more favor in the eyes of lenders.

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. Read the fine print of your loan terms for any prepayment fee and compare that to the interest  you could save.

Avoid Prepayment Penalties

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 should carefully 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. 

On the other hand, some personal loans have no prepayment penalties at all.

Keep an Eye on Your Credit When Paying Off a Personal Loan Early

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.

Whether you choose to pay off your personal loan early or spend any extra cash elsewhere is up to you. By understanding the pros and cons of an early payment, you can make informed decisions with your money.