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Paying off a personal loan before the loan term ends may not be the best move if the loan includes a prepayment penalty. Some personal loans have prepayment penalties (also called early payoff fees) that can reduce or erase the financial benefit of paying off a loan early. Here's what you need to know about paying off a personal loan ahead of schedule, how to decide if doing so makes financial sense and how to avoid prepayment penalties.
What Is a Personal Loan Prepayment Penalty?
A prepayment penalty is a fee the lender charges when a borrower repays a loan before the agreed-upon loan term ends. Lenders count on revenue from interest on the money you borrow, and they may charge a fee to help make up for lost profits that result if you pay back the loan early.
Not all personal loans have prepayment penalties.
However, some personal loans do charge prepayment penalties. If a prepayment fee exists, it must be stated in the disclosures that are part of your loan agreement. You can also find out whether a loan has a prepayment penalty by asking the lender.
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How Much Does a Prepayment Penalty Cost?
Lenders may use various methods to calculate the amount of a prepayment penalty. Typically, prepayment penalties are calculated in one of three ways:
- Flat fee: You'll pay a set dollar amount regardless of the loan's remaining balance when you pay off the loan.
- Interest-based: The lender charges a specific time period's worth of interest—say, 12 months' worth—if you pay off your loan early.
- Percentage of balance: Some lenders assess a percentage of your remaining loan balance, such as 1% or 2%, as a prepayment penalty. This method may use a sliding scale system in which the percentage is higher at the beginning of the loan term and lower as you get closer to the end.
When you're considering paying off a personal loan that has an early payoff fee, review your loan contract and crunch the numbers to see exactly how much you'll owe versus paying interest.
Personal Loan Prepayment Penalty Example
How do prepayment penalties work in practice? Suppose you have three years of payments remaining on a $25,000 personal loan with a five-year term. The loan has a 9.41% interest rate that would result in a total of $6,436.86 in interest charges over five years. Two years in, you've made 24 monthly payments of $523.95, for a total of $3,952.77 in interest and $8,621.98 in principal so far.
If you can afford to pay off the remaining $16,378.02 loan balance, you'd save yourself $2,484.09 in interest you would have paid had you taken the full five years to pay off the loan. To offset the loss, the lender charges a prepayment penalty of 2% of your balance, or $327.56. That still saves you $2,156.53 in interest.
Of course, saving on interest isn't the only factor involved in deciding to pay off a personal loan early. Consider how paying off the loan will affect:
- Your credit score: A personal loan is a type of installment loan, like a student loan or mortgage. If you have no other installment loans, continuing to make regular payments on a personal loan could help improve your credit score by adding to your credit mix and adding additional on-time payments to your credit file. After the personal loan is paid off, the account will be closed. Since closed accounts are weighted less than open ones when calculating your credit score, this could potentially cause your score to dip.
- Your debt-to-income ratio (DTI): Your DTI reflects the percentage of your gross monthly income that goes to pay recurring monthly debt. Although your DTI doesn't impact your credit score, a DTI of 43% or more could make it harder to qualify for a mortgage. If you're preparing to apply for a mortgage but don't want to repay a loan early, you can reduce your DTI by paying down other debt, such as credit card balances. This could also help your credit score by lowering your credit utilization.
- Your savings: Paying off a personal loan early may not be the best use of extra money. You might be better off putting the cash into your emergency fund, investing it for retirement or socking it away for a down payment on a house.
Experian's personal loan calculator can help you determine if paying off a personal loan early makes sense for you.
How to Avoid Prepayment Penalties
You can avoid prepayment penalties by shopping around for a personal loan that doesn't have one.
- Do your research. Many lenders specifically advertise personal loans without prepayment fees. You can also visit their websites to look at loan terms.
- Use Experian. Log in to your Experian account and you can get matched with loans that fit your credit profile; filter by those without prepayment fees.
- Ask the lender. Not sure if a loan comes with prepayment penalties? Ask the lender.
- Be ready to negotiate. You've found a loan that has great terms...except for the prepayment fee. Ask the lender if they can remove the prepayment penalty. They may be willing to do so to earn or keep your business.
To Prepay or Not to Prepay?
Total personal loan debt rose 5.9% between 2020 and 2021, according to Experian data. Personal loans can be useful tools for paying off high-interest debt, handling financial emergencies or financing big-ticket expenses like weddings or home repairs. Making personal loan payments on time can even help improve your credit score as it's a key component of responsible use of credit.
Before paying off a personal loan early, check your credit report to see how closing the loan account would affect your credit mix. Also weigh potential interest savings against the cost of prepayment penalties. Taking all these factors into account will help you make the decision that best supports your financial goals.