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When it comes to paying off your debt, you might have heard that paying off your balance as quickly as possible can help save you money in the long run. And it often is. If you pay off your credit card balance in full, for example, you’ll save on interest charges.
As a general rule, the more you are required to repay a loan or other debt, the more interest you will pay over the life of the loan. It therefore seems obvious that repaying your personal loan early would be a good idea, but not so quickly.
Below, Select explains why personal loans are different from other types of debt and how prepayment can impact your credit score and finances.
How are personal loans different from other debts?
There is an abundance of financial products when you need the money to pay for something. And everyone is a little different, so it’s virtually impossible to have a one-size-fits-all approach to debt repayment. You’ll want to consider factors like interest rates, billing cycles, loan terms, and potential fees when developing your plan.
Student loans are used to pay for tuition and other costs associated with an education. Auto loans are meant to help you buy a vehicle. Personal loans can be used for just about any expense – a wedding, home improvement, vacations, and even debt consolidation. While you may need to explain how you plan to use the money on your application, there is usually no hard and fast rule about how you use your personal loan.
Like a car loan or a student loan, you will receive a sum of money that you have to repay in monthly installments over a fixed period (called the loan term) along with interest charges.
The repayment period for a personal loan can be anywhere from two to five years, but some can be up to seven years. Auto loans typically last six years on average, while student loans typically last for 10 years, but it can take longer if you’re on an income-based repayment plan.
Personal loans are different from credit cards in that there is no set time limit for paying off your credit card debt, however, the faster you pay off the balance, the less interest charges you will accumulate. (Ideally, you pay off your balance on time each month and never pay interest.) Credit cards also have a credit limit, which is usually much smaller than the average personal loan amount requested by borrowers.
While the interest rate on personal loans is usually much lower than on credit cards, it really depends on how much you are applying for and your credit score. Keep in mind that the higher your credit score, the more favorable your terms can be; a good credit score will help you get approved for a lower interest rate or a longer term loan, or both.
Sometimes personal loans come with a few extra fees, including a set-up fee and a prepayment penalty. These are the prepayment charges that you should be wary of.
Is it possible to repay a personal loan in advance?
It’s possible to prepay your personal loan, but you might not want to. Making an additional payment each month or allocating some or all of a windfall to your loans could help reduce your repayment period by a few months. However, some lenders may charge a prepayment penalty fee for early repayment of the loan.
The prepayment penalty can be calculated as a percentage of your loan balance or as an amount that reflects how much the lender would lose in interest if you paid off the balance before the end of the loan term. The calculation method will vary from lender to lender, but prepayment penalties will be described in your loan agreement.
There are a number of lenders that do not charge a prepayment penalty. SoFi, for example, will not charge you a prepayment fee for prepaying the loan, and there are also no origination or late payment fees. If you prefer to look to a peer-to-peer lender, LendingClub is another option for loans with no prepayment charge. Generally, you will need good to excellent credit to qualify for the best personal loans on the best terms.
SoFi personal loans
Annual percentage rate (APR)
5.99% to 18.85% when you sign up for automatic payment
Purpose of the loan
Debt consolidation / refinancing, home renovation, moving assistance or medical expenses
How Does Prepaying a Personal Loan Affect Your Credit Score?
When you pay off your credit card balance, you reduce the amount of your credit card debt compared to your total credit limit. This means that your usage rate, which is 30% of your credit score, is reduced and it can help give your credit score a little boost. So shouldn’t it be the same when paying off your personal loan?
According to Experian, personal loans do not work the same way because they are installment debts. Credit card debt, on the other hand, is revolving debt, which means there is no set repayment period and you can borrow more money up to your credit limit as you go. as you make payments. Installment debt is a form of credit that requires you to repay the amount in regular and equal amounts within a specified time period. When you have finished repaying the loan, the account is closed.
When you take out a personal loan, you increase the number of accounts opened on your credit report. The loan can also improve your credit mix, which accounts for 10% of your FICO score. But when you pay off an installment loan, it shows up as a closed account on your credit report. Closed accounts are not as weighted as open accounts when calculating your FICO score, so once you pay off your personal loan, you will have fewer open accounts on your credit report.
If you pay off the personal loan earlier than your loan term, your credit report will reflect a shorter account life. The length of your credit history is 15% of your FICO score and is calculated as the average age of all your accounts. As a general rule, the longer your credit history, the better your credit score will be. Therefore, if you prepay a personal loan, you could reduce the average length of your credit history and your credit score. The extent of the change in your credit score will depend on your overall credit profile.
Having a low credit score can put you at a disadvantage, making it difficult to get an apartment, good financial products, or even a job. However, adopting good financial habits, such as making consistent, on-time payments and avoiding asking for too many new lines of credit at the same time, can help boost your score.
At the end of the line
Personal loans can be a convenient and affordable way to cover a significant expense and improve your credit history when used responsibly. But as with any financial tool, you need to carefully consider whether your circumstances will allow you to get the most out of a personal loan. Prepaying the loan can put you in a situation where you have to pay a prepayment penalty, potentially wiping out any money you would save on interest, and it can also impact your credit history.
If you think there is a possibility that you want to pay off the loan sooner than the terms require, you should consider submitting a request to a lender who will not charge a prepayment penalty. Always do your research and read the terms and conditions before purchasing a new financial product so that you understand what to expect.
Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.