Paying off debt is a financial priority for many. After all, paying interest is expensive and sending money to a creditor every month isn’t fun.
If you dream of getting rid of your debts, you need to decide which loans to pay off first. You should focus on paying off high-interest debt, like overdue credit card balances or payday loans, as soon as possible. But other types of debt have more favorable terms, so early repayment may not make sense.
If you have a personal loan, for example, prepaying it might be right for you. But it is also possible that you are better off keeping the loan and making minimum payments. Ask yourself these key questions to help you decide whether prepaying personal loans is a good idea.
What is the interest rate on your personal loan?
The lower your interest rate, the less sense it makes to prepay the loan.
If you’re not paying a lot of interest, it might not be a good idea to aggressively pay off your personal loan. For example, if you have a loan with a good 5% interest rate, prepaying it would only give you a 5% annual return. You could probably get a better return by investing in the stock market.
But if you have a personal loan with a high interest rate, paying it off as quickly as possible becomes imperative. If you pay 15% interest, for example, few investments offer a higher rate of return than paying off the loan.
What other debt do you have?
Personal loans have lower interest rates than other types of debt. This includes:
If you have other debt at a higher interest rate, focus on repayments first. Make only the minimum payments on your personal loan. Getting rid of high interest debt will save you more money than paying off a personal loan.
On the other hand, it’s usually better to pay off your personal loan first if your only other debt is a mortgage. Mortgages come with tax breaks and lower interest rates than personal loans.
Does your personal loan have a prepayment penalty?
Some personal loans come with a prepayment penalty. If you pay off the loan before it is due, you will have to pay a fee. Prepayment penalties dramatically reduce the savings that result from prepaying your loan.
Compare your prepayment penalty to what you could save by prepaying your loan. You may find it better to continue paying as planned. If you want to save a small amount of money because of the prepayment penalty, do something else with your available money. You will probably get a better return from it.
What else could you do with your money?
The early repayment of a personal loan has an opportunity cost. For example, if you are spending extra money on your personal loans, you may not be able to get an employer match on your company’s 401 (k). In this case, you would forfeit a 100% ROI.
Likewise, you can start a business with the money you use to prepay a personal loan. Entrepreneurship can be very profitable, so you could get a higher return.
If you’re trying to prepay a personal loan and don’t have emergency funds, you may need to borrow if something goes wrong. These emergency loans will likely have a higher interest rate.
Think carefully about what you might be missing out on when you invest the extra money in your personal loan. If any of these other goals might be a better use of your limited funds, consider prioritizing them.
Does prepaying your personal loan make sense to you?
There is no right answer to the question of whether prepaying a personal loan makes sense. It could be a smart move if you were otherwise wasting money on unnecessary purchases. But it might not be the best idea to pay off a higher interest rate debt instead or invest the money and get a better return.
Consider your financial goals, your financial situation, and the cost of the loan before you pay off your personal loan early. If there are better things you can do with your money, continue to pay the minimum on your personal loan and take other steps to improve your overall financial situation. You will eventually be free of your debts and you could be in a much better financial situation by then.