Is it smart to pay off your personal loan early?

You're staring at your monthly loan statement and you're not happy with how slowly the balance is dropping. You think you could rid yourself of the debt ahead of schedule by making extra payments. But you're not sure whether it's the best use of your spare cash right now.

Paying off a personal loan early can be a smart move in some cases—but not all of them. The right decision depends on your specific situation. With a little knowledge about early loan payoffs, you'll be ready to decide how quickly you should pay back your personal loan.

The upside of paying off a personal loan early

An early loan payoff can be beneficial in a few ways.

You could save money on interest

Part of how personal loans work is that part of every payment goes to interest and part to your principal. The amount that covers interest is based on the size of your principal each month.

When you make extra payments, you can use them to pay down your principal faster. A lower principal means less interest, which means more of each payment goes toward your principal. Even one or two extra payments in a year could add up to significant interest savings overall.

You could free up funds for other goals

Early payoff could also make managing money easier. You'll simplify your finances with one less bill to pay, and you'll free up more money for your budget. You can redirect the money that was going to loan payments toward another goal, such as building an emergency fund or contributing to a 401(k).

You could improve your debt-to-income (DTI) ratio

If you're planning to apply for any new loans or credit cards, an early loan payoff can potentially help with that, too. Lenders typically look at your debt-to-income (DTI) ratio during the application process.

Your DTI ratio is your monthly debt payments, including housing, divided by your pre-tax income. A lower DTI ratio generally improves your chances of approval. You can find yours using our DTI calculator.

For example, imagine you have $2,000 in monthly debt payments and make $5,000 per month before taxes.

Here's what your DTI would look like:

• $2,000 / $5,000 = 0.40

• 0.40 x 100 = 40%

In this example, your DTI ratio would be a little on the high side. But if you decide to pay off a personal loan early, cutting a $300 payment from your monthly bills, your DTI would drop to 34%. This could improve your ability to get new credit.

When an early loan payoff isn't a good idea

There are a few situations when paying off your loan early isn't the best idea.

If the money is better used elsewhere

It's better not to pay off a loan early if it's going to hurt your finances in other areas. For example, it's usually not a good idea to dip into emergency savings for an early loan payoff. An unforeseen expense can strike at any time, and your emergency fund provides you with a safety net and peace of mind.

Be careful not to put your future at risk, either. If paying off your personal loan means skipping retirement contributions, you may be better off making the usual monthly payments.

If the lender charges a fee to pay off your loan early

Some personal loans charge prepayment penalties for early payoffs. The extra fees could end up costing you more than the money you save. Before you start paying extra, check if your loan has a prepayment penalty. If so, find out the details. Many prepayment penalties only kick in with substantial early payments.

An early loan payoff is a luxury. If you can manage it without any negative side effects, then go for it. If it will cause issues elsewhere or strain your finances, there's nothing wrong with following your loan's original payoff schedule.

How paying off a personal loan early could affect your credit

You might wonder whether paying off your personal loan early will hurt your credit score. The short answer: Any dip in your score is usually small, and your score can recover as you keep making on-time payments on other accounts.

Two factors in the FICO Score formula are worth knowing:

• Credit mix (10% of your FICO Score). FICO scores reward a mix of account types, like credit cards and installment loans. When you close a personal loan, you remove one active installment account from that mix, which could nudge your score down slightly.

• Average credit age (15% of your FICO Score). The length of your credit history matters. A closed loan may shorten the average age of your open accounts, and a shorter history could lower your score by a few points.

The good news: The benefits of paying off your loan, like a lower DTI ratio and less overall debt, often outweigh a small score dip. As long as you continue on-time payments on your remaining accounts, your score could bounce back over time.

Achieve is not a Credit Repair Organization and does not provide credit repair services.

Questions to ask before you pay off your personal loan early

Here are a few smart questions to ask yourself if you're thinking about paying off a personal loan early:

• Does my personal loan have a prepayment penalty? If so, your best option may be to follow the regular payment schedule.

• Is this my highest-interest debt? If you have accounts with higher interest rates, such as credit card debt, prioritize those debts to save more money.

• Do I have enough in my emergency fund? A general recommendation is to have at least three months of expenses saved.

• Will this lead to financial strain? If you'll need to work large amounts of overtime or follow an extremely strict budget, you may want to save yourself the stress.

Other ways to pay off your loan faster

Even if you can't pay off the rest of your loan in one fell swoop, you have plenty of alternatives that could speed up your progress on your loan. For a simple option, figure out if you can make one extra payment per year. You'll still pay off your personal loan more quickly, without needing to drain your savings account.

If your goal is to save on interest, another option is refinancing your loan. You could get a new loan with a lower interest rate and use it to pay off your original loan. Refinancing could be a good move if you've made all your loan payments on time and your credit score has increased or interest rates have decreased since you first got a loan.

If you have multiple debts, you could also look into debt consolidation loans to simplify your finances and potentially get a lower rate. With debt consolidation, you get a new loan and use it to pay off multiple accounts. After that, you only need to make a single monthly payment on your debt consolidation loan. Check out our guide on how debt consolidation loans work to learn more.

In either case, get a new loan term that's equal to or shorter than your current loan's repayment term. Extending your term would mean it takes longer to pay off the debt, and it could add extra interest cost even with a lower rate.

What's next: Find your balance

You're already in a good position. You know you're going to pay off your personal loan—it's just a matter of when. The goal isn't just to be debt-free fast, but to be debt-free and on financially solid footing.

Consider what kind of loan payment fits your budget and financial goals, while keeping your peace of mind. If you'd like more help, learn more about personal loans and what payoff timeline works for you.