Does paying off a loan early hurt credit?
Paying off a loan early may initially cause your credit score to drop because a paid-off loan is considered a closed account. Having a blend of mix of open accounts is something lenders like to see.
But the drop in your credit score is really more of a dip that will likely recover as time goes on.
Credit scores are not the end-all, be-all of finance. While they do play an important role in your ability to borrow funds from lenders, it’s also important to be able to pay off the loan. Plus, it reduces your debt-to-income ratio, another factor that’s considered with credit scores.
That said, It is almost always better to pay off a loan early, and that supersedes a small dip in your credit score. There are other ways you can improve your credit score, too, so don’t worry about that dip too much.
Do you save money by paying off a loan early?
Although paying off the current balance of a loan may look intimidating and expensive, it’s actually more expensive to pay the loan through multiple installments, especially if you’re only paying the minimum amount required of you.
Loans are made up of 2 components: principal and interest (some loans have 3 components if they also have an origination fee, but that’s not relevant for this explanation).
Principal is the original amount of money you’ve received in a loan. For the sake of simplicity, let’s say you’ve borrowed $1,000 from a lender. That $1,000 is your principal.
But lenders need to make money from the loan, so they’ll add what’s called an interest rate on top of that loan. Again, to keep the math simple, we’ll say this $1,000 loan came with a 10% interest rate with a minimum monthly payment of $100.
If you paid $100 each month to repay the $1,000 loan, your total payment would be $1,084.54 and would take 30 months to pay off.
But wait a second — shouldn’t paying $100 a month for $1,000 only take 10 months? And where did that $84.54 come from?
The answer to both of these questions is interest. Not all of your monthly payments go to only the principal. There’s interest added on top of that. So you’re paying off both interest and principal each month. The interest can really add up, especially if you’re dealing with higher interest rates.
There are a wide variety of specialized calculators that can help you better understand what your monthly personal bill payment will look like if you just stick to the minimum payment. You can get a clearer idea of how long that repayment will take and possibly come up with a payment plan so you can have a timeframe for when you’d have the funds to pay the rest of the loan off in full.
If you pay off the loan earlier, you don’t have to pay as much interest and are actually saving yourself money in the long run.
What happens if you pay a loan off early?
If you pay a loan off early, you will pay the lender less interest than if you paid it off in multiple installments of the minimum payment.
You’ll be saving yourself more money because you’ll also be paying more interest with longer loans.
Why you should pay off a personal loan early
To recap, paying off a personal loan (and any loan, for that matter) early is almost always a good thing because:
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