Early Loan Payoff Pitfalls
Before You Use an Early Payoff Strategy
Paying off debt is rarely a bad idea because you eliminate interest costs and free up cash flow. But it’s always worth evaluating the pros and cons of any strategy before you do something that can’t be undone.
If you receive a lump sum of money, or you’ve managed to save a significant amount that you’d like to put to work, that’s great—you’ve got options. Now, the important thing is to choose the best option. Keep in mind that you don’t have to choose only one action. You can do several different things with your money.
You have a wide range of options: You can pay off some of your debt, all of it, or none of it.
The best strategy depends on the types of loans you have, any features of those loans (like potential forgiveness), and your capacity to take risks with alternative approaches.
Alternatives to Early Payoff
If your monthly loan payments are manageable, think about how else your cash might come in handy. You probably don’t want to waste money on short-term thrills or luxury items, but there might be smart ways to invest that money.
Do you have enough savings on hand to absorb any surprises that come your way? Keep three to nine months’ worth of cash (or more, if you’re the cautious type) in a savings account or money market account—just in case something expensive happens. The goal is to avoid taking on high-interest-rate debt like credit card debt to pay for emergencies. It would be unfortunate to pay off low-interest-rate loans and then take on toxic credit card debt immediately afterward.
Investments for the Future
It may be possible to use your funds to improve your finances down the road.
Home improvements: Does your home need any work? Focus on projects that add to your home equity or prevent expensive repairs. Research which projects add the most value for the next buyer.
Future income: Would you earn more if you improve your skills, earned an advanced degree, or completed a professional certification? If so, that higher-income pays dividends for years to come.
Business: Are you willing and able to take the risk of starting a business? Most businesses fail, so proceed with caution, but if you have a strategy and a backup plan, it could make sense to move forward.
Long-term investing: If you need to make progress on goals like retirement or education funding, it could make sense to invest prudently for those goals. However, investments don’t have guaranteed returns, and paying off debt may be safer in the short-term.
Paying off debt has a “guaranteed” benefit when you stop paying interest on your loan balance. Other investments might or might not pay off.
No Turning Back
Why might you hesitate to pay off debt early? Because you have numerous options when you have cash, and those options may disappear after you use the money to pay off debt. Granted, you’ll free up cash flow because your monthly payments will go away (or shrink—although that’s not necessarily the case if you make a lump sum payment on your mortgage). As a result, you might be able to replenish your cash supply easily.
Once you make a payment, you usually can’t get the money back. Especially when you really need money, getting a loan is difficult (if you lose your job, for example). Getting a loan quickly isn’t always easy.
When emergencies strike, cash in your bank account is the quickest and easiest source of funding.
With some loans, you might be able to pull money back out, but there are no guarantees. For example, if you pay down your mortgage, you’ll have more equity in the property, and you might be able to borrow against that equity with a second mortgage. But to qualify for the loan, you need to meet specific criteria, and the process may take time.
Type of Loan Matters
As you review your options, evaluate the kind of loan you have. If you’ve got toxic credit card debt with a high-interest rate or payday loans, it almost always makes sense to wipe out those debts. Also, your credit card debt continues to grow if you only pay the minimum on your cards. You may consider using a loan to consolidate debt or pay off these high-interest loans early.
Auto loans are also nice to get rid of early. With no payments, you can save for your next vehicle or put money toward important goals. With other loans, paying off debt might not be a clear winner.
Federal student loans, for example, feature certain benefits—like subsidized interest—that you lose (and never get back) if you pay off the loan early. You might have the ability to suspend or lower your payments based on your financial situation, and you might even get your loans “forgiven” or paid off depending on your career or payment program. If you work in public service (in nonprofits, education, law enforcement, or military, for example), research benefits available to you before you write a big check. Even doctors at some hospitals qualify for public service loan forgiveness.
With some loans, you don’t save money by paying early. Some lenders build fees and interest into loan products (which is sneaky, and illegal in some states) so that you pay the same amount no matter when you pay. If your loan is a precomputed loan, find out what happens if you pay early.