What to Consider Before You Pay Off Debt Early
Pros and Cons of Early Debt Repayment
Paying off debt is rarely a bad idea because you eliminate interest costs and free up cash flow. But once you make a payment, you can't get that money back. Before you make that kind of financial commitment, it's worth considering the implications of an early payoff strategy.
When to Consider Early Debt Payoff
If you receive a lump sum of money, your income has increased, or you’ve managed to save a significant amount that you’d like to put to work, you have options for what to do with that money. 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.
If you are considering early payoff, you have a range of options. You can choose to pay off some of your debt, all of it, or none of it.
The best strategy depends on the types of loans you have, the terms and features of those loans, and your capacity to take risks with alternative approaches.
Pros and Cons of Early Debt Payoff
Before you choose whether to pay off part or all of your debt early, consider the advantages and drawbacks you can be faced with as a result.
Pros of Early Debt Payoff
- Save money. For types of high-interest debt, such as credit card debt or some personal loans, you are losing significant money to interest if you only make the minimum required payment, or even pay slightly more than the minimum. Paying off the full amount of your debt saves you money.
- Increase cash flow. In many cases, when you pay off debt early you do free up more cash on a monthly basis. This is because your monthly payments will disappear or shrink (although that’s not necessarily the case if you make a lump sum payment on your mortgage).
Cons of Early Debt Payoff
- Limit available cash. When you have cash, you have a safety cushion and multiple options for what to do with your funds. Those options may disappear after you use the money to pay off debt.
- No turning back. Once you make a payment, you usually can’t get the money back. If, for example, you lose your job soon after paying off significant debt, you cannot undo that decision and may need to apply for a personal loan to cover your monthly expenses. And 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.
Types of Loans to Pay Off Early
As you review your options for debt payoff, take into account the kind of loan you have.
If you have credit card debt or payday loans, it almost always makes sense to wipe out those debts. These types of debt charge high monthly interest and can end up costing several times the value of the original debt. You may consider using a loan to consolidate debt or pay off these high-interest loans early.
Credit card debt continues to grow if you only pay the minimum on your cards.
Auto loans are also beneficial to get rid of early because cars depreciate in value as soon as you start driving them, which means you cannot get the full cost of your car back even if you sell it to pay off the balance of your loan. Once your auto loan payments are gone, you can save for your next vehicle or put money toward important goals.
With some loans, you don’t save money by paying early. Some lenders build fees and interest into loan products (this is illegal in some states) so that you pay the same amount no matter when you pay. If your loan is a precomputed loan, investigate the terms of your loan to find out what happens if you pay early.
Paying off your mortgage early be either a good or bad idea depending on the terms of your loan. If you pay off a 30-year mortgage in only 15 or 20 years, for example, you can save tens of thousands, or even hundreds of thousands, of dollars in interest depending on the size of your loan.
However, some mortgage lenders charge significant fees or penalties for early repayment, especially during the early years of your loan. These are common with adjustable-rate mortgages but can be present in fixed-rate mortgages as well. Before you repay your mortgage early, be sure you understand the terms of your loan. Otherwise, you may find you owe significantly more money than you expected.
Deciding Whether to Pay Off Student Loans Early
For some borrowers, paying off their student loans frees up huge portions of their income and allows them to make progress or major life goals such as saving for emergencies, paying off credit cards, buying a house, starting a family, and more.
However, if you have federal student loans, early payoff is not always the best idea. Federal student loans have 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.
For some professions, you might be able to get your loans “forgiven” or paid off depending on your career or payment program. Before you repay the cost of your loans early, look into loan forgiveness programs if you work full-time in:
- law enforcement
- the military
- nonprofit healthcare
- federal, state, local, or tribal government
- AmeriCorps or the Peace Corps
Not all positions in these fields will be eligible for loan forgiveness, but in some instances, you may be able to avoid paying back most of your debt if you are eligible for the Public Service Loan Forgiveness program.
Alternatives to Early Debt Payoff
If your monthly loan payments are manageable, think about how else your cash might come in handy. Instead of paying off low-interest loans, or loans that are eligible for forgiveness, there might be other smart ways to invest your money.
Build an Emergency Fund
Do you have enough savings on hand to absorb any surprises that come your way? Keep three to nine months’ worth of living expenses 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.
Make Strategic Investments
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 hoping to start a business? If you have a solid strategy and a backup plan, your available cash may allow you to start a business on healthy financial footing without taking on debt or worrying about investors.
- Long-term investing: Saving for goals like retirement or education expenses is most effective if you take advantage of compound interest. This means starting your investing as early as possible. If you have available cash, you can benefit your future self by investing some or all of it in your 401(k), IRA, or 529 accounts.
It's important to remember that no investments have guaranteed returns. Paying off debt, by contrast, has a guaranteed benefit of lowering or eliminating interest payments on your loan balance. Depending on your financial situation and type of debt, the advantages of early debt payoff may outweigh any drawbacks.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Consumer Financial Protection Bureau. "Can I Be Charged a Penalty for Paying off My Mortgage Early?" Accessed Apr. 10, 2020.
Consumer Financial Protection Bureau. "Data Point: Final Student Loan Payments and Broader Household Borrowing," Pages 13-15. Accessed Apr. 10, 2020.
Federal Student Aid. "Get Temporary Relief." Accessed Apr. 10, 2020.
Federal Student Aid. "Public Service Loan Forgiveness (PSLF): Qualifying Employment." Accessed Apr. 10, 2020.