Early Payoff Pitfalls
Before you use an Early payoff strategy
Paying off debt is rarely a bad idea. But it’s always worth evaluating the pros and cons before you do something that can’t be undone.
If you’ve come into some money, or you’ve just saved up a large chunk of change, that’s a good thing: you’ve got options. Now the important thing is to choose the best option. Keep in mind that you don’t have to choose one thing. You can do several different things with your money – there’s no black or white (you can pay off some of the debt, all of it, or none of it).
Alternatives to early payoff
If your debt payments are manageable, think about how else your cash might come in handy. It’s not wise to blow the money on a short-term thrill, but there might be smart ways to invest that money.
Emergency fund: 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’d be a shame to pay off your low-interest-rate student loans and then go into credit card debt.
Investments for the future: does your home need improvements (which you can capitalize on later)? Would you earn more if you improved your skills, got an advanced degree, or earned a professional certification? Are you willing and able to take the risk of starting a business? Consider using the money for something that will pay dividends for many years to come (just remember that you might be taking a risk – and paying off debt is pretty much a guaranteed money-saver).
No turning back
Why would you hesitate to pay off debt early? Because you’ve got options when you’ve got cash, and those options go away once you pay off your 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).
Once you make a payment, you usually can’t get the money back. Especially when you really need the money (when you’ve lost your job, for example), getting a loan is difficult. Getting a loan quickly (for emergencies, for example) isn’t easy either.
With some loans, you might be able to get money back out, but there are no guarantees. For example, if you pay down your mortgage, you’ll have a lot more equity, and you might be able to borrow against that equity with a second mortgage. Other types of loans are less friendly.
Type of loan matters
As you evaluate your options, evaluate the type 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. See what happens if you only pay the minimum on your cards.
With other loans, things aren’t so clear. Federal student loans, for example, come with certain benefits that you’ll give up (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. If you work in public service (in nonprofits, education, law enforcement, or military, for example), find out what benefits are available before you write a big check.
Finally, with some loans, you won't really 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 before you write a check.