Paying down a personal loan before the loan term ends may not be the best move if the loan includes a prepayment penalty. Some unsecured loans have prepayment penalties (also known as early payoff fees) that can reduce and sometimes erase the financial benefit of paying off financing early. This is what you need to know about paying off an unsecured 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 rely on revenue from interest on the money you borrow, plus they may charge a fee to help make up for lost profits that result should you repay the borrowed funds early.
Not every personal loans have prepayment penalties.
However, some unsecured loans do charge prepayment penalties. If a prepayment fee exists, it should be stated in the disclosures which are a part of the loan agreement. You can also find out whether financing includes a prepayment penalty by asking the lending company.
How Much Does a Prepayment Penalty Cost?
Lenders may use various techniques to calculate the amount of a prepayment penalty. Typically, prepayment penalties are calculated in a single of three ways:
- Flat fee: You'll pay a set amount of money regardless of the loan's remaining balance whenever you pay off the loan.
- Interest-based: The lending company charges a specific time period's worth of interest—say, 12 months' worth—if you repay your loan early.
- Percentage of balance: Some lenders assess a portion of the remaining loan balance, for example 1% or 2%, as a prepayment penalty. This method may use a sliding scale system where the percentage is higher at the beginning of the borrowed funds term minimizing as you become nearer to the end.
When you're considering paying off an unsecured loan that has an early payoff fee, take a look at loan contract and crunch the numbers to see just how much you'll owe versus paying interest.
Personal Loan Prepayment Penalty Example
How can prepayment penalties operate in practice? Suppose you've 3 years of payments remaining on the $25,000 personal bank loan with a five-year term. The borrowed funds includes a 9.41% interest rate that will result in a total of $6,436.86 in interest charges over five years. Two years in, you have made 24 monthly obligations of $523.95, for any total of $3,952.77 in interest and $8,621.98 in principal so far.
If you're able to afford to remove the remaining $16,378.02 loan balance, you'd save yourself $2,484.09 in interest you would have paid had you taken the entire 5 years to repay the loan. To offset the loss, the lending company charges a prepayment penalty of 2% of the balance, or $327.56. That still helps you save $2,156.53 in interest.
Obviously, conserving interest isn't the only factor involved in choosing to pay off an unsecured loan early. Consider how paying off the loan will affect:
- Your credit rating: A personal loan is a type of installment loan, like a education loan or mortgage. For those who have not one other quick installment loans, continuing to create regular payments on a personal loan may help raise your credit score by adding to your credit mix and adding additional on-time payments for your credit report. Following the personal bank loan pays off, the account is going to be closed. Since closed accounts are weighted less than open ones when calculating your credit score, this might potentially cause your score to dip.
- Your debt-to-income ratio (DTI): Your DTI reflects the percentage of your gross monthly income which goes to pay for recurring monthly debt. Although your DTI doesn't impact your credit score, a DTI of 43% or more might make it harder to qualify for a home loan. If you are getting ready to apply for a mortgage try not to wish to repay financing early, you can lower your DTI by paying down other debt, such as credit card balances. This might also help your credit score by lowering your credit utilization.
- Your savings: Paying off a personal loan early might not be the very best use of extra money. You may be better off putting the money to your emergency fund, investing it for retirement or socking it away for a deposit on the house.
Experian's personal loan calculator will help you determine whether paying down an unsecured loan early makes sense for you personally.
How to Avoid Prepayment Penalties
You are able to avoid prepayment penalties by looking around for any personal loan that doesn't have one.
- Do your quest. Many lenders specifically advertise personal loans without prepayment fees. You may also visit their websites to look at loans.
- Use Experian CreditMatch™. 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 includes prepayment penalties? Ask the lender.
- Be ready to negotiate. You've found a loan which has great terms…aside from the prepayment fee. Ask the lender whether they can take away the prepayment penalty. They might be willing to achieve this to earn or keep the business.
To Prepay or otherwise to Prepay?
Total personal loan debt rose 5.9% between 2023 and 2023, according to Experian data. Personal loans can be useful tools for paying down high-interest debt, handling financial emergencies or financing big-ticket expenses like weddings or home repairs. Making personal loan payments promptly can even help improve your credit rating as it's a key component of responsible use of credit.
Before paying off an unsecured loan early, check your credit report to see how closing the loan account would affect your credit mix. Also weigh potential interest savings from the price of prepayment penalties. Taking each one of these factors into consideration can help you make the decision that best supports your financial goals.