When you have money available, paying off debt often is a good choice. In addition to the psychological benefits of being debt-free, you enjoy measurable financial benefits. Paying off loans early isn’t always the optimal strategy, but it’s rarely a horrible one.
To decide what’s best in your case, evaluate how you benefit from debt, and compare those benefits to the cost of keeping loans in place. You usually save money when you eliminate debt early, but you might have valid reasons for taking an alternative approach.
The best reason to pay off debt early is to save money and stop paying interest. Interest charges don’t buy you anything except time. Rather than needing the full amount to buy a home or a car right now, you can spread out the payments over several years. Your house doesn’t get any bigger when you pay interest on a mortgage, and you don’t get your interest back when you sell. So, it's best to not pay for any more time than you need.
Some loans drag on for 30 years or more, and interest costs add up over time. Other loans might have shorter terms, but high-interest rates make them expensive. With high-cost debt, such as credit card debt, it’s almost a no-brainer to repay as quickly as possible: Paying only the minimum is a bad idea. Over your lifetime, you'll keep more of what you earn if you pay off loans quickly.
Improve Financial Strength
Once you pay down debt, you’re in a stronger financial position. The money you’ve been putting toward monthly payments becomes available for other uses. For example, when you pay off an auto loan, you can direct the amount you were spending on monthly payments toward savings or paying off other debts.
You also become more attractive as a borrower. Lenders need to be sure you have enough income to repay loans and that existing loans don’t already eat up too much of your monthly income. To do so, they calculate the percentage of income that goes toward debt payments, known as a debt-to-income ratio. When you pay off loans early, you improve your ratio and are more likely to get approved for a new loan on favorable terms.
Your credit scores also can improve when you pay down debt. Part of your credit score depends on how much you’re currently borrowing, relative to the maximum amount that you potentially could borrow. If you’re maxed out, your credit scores will be lower, but paying down debt frees up borrowing capacity—which you hopefully won’t need to use.
Peace of Mind
Eliminating debt can be rewarding and reduce stress. Some people choose to pay off loans as soon as they possibly can even if they know it doesn’t make the best financial sense. That’s fine, as long as you’re mindful of what you’re doing and why.
You can’t put a price on happiness. Perhaps you want to reduce debt before retiring, you’re sick of making monthly payments, or you hate the idea of paying interest to lenders. Evaluate the pros and cons of using debt, and make an informed decision that you can live with.
When Not to Pay Early
Paying down debt early leaves less money in your pocket for other things than if you were to pay only the minimum amount due each month. That might mean enjoying fewer luxuries in your monthly budget or making do with a smaller cash cushion, which could make it more difficult to pay unexpected expenses. What's more, you'll pay an opportunity cost: You'll have to come up with additional funds to put toward other goals, such as retirement or a down payment on a house, for example.
Only you can determine whether your money is better spent paying down debt or using it to invest in retirement, a new home, or education expenses. If the interest you earn on investments is greater than the interest you're paying on your debt, it makes more sense to invest than it does to pay off the debt early. This rarely is a simple equation, however, so it's best to consult with a financial professional.
If you have a precomputed loan, you won’t save by repaying early, because the costs are already baked into the loan. Most standard loans, however, calculate interest daily or based on the balance due on a certain date each month. Be sure you understand the terms of your loan if you plan to pay the debt early.
How to Do It
Now that you know more about paying off those loans, you may be eager to move forward. In many cases, it’s as simple as sending extra money, whether you wipe out the debt with one payment or just pay a little extra each month. Call or email your lender, and explain what your goals are. Ask how to proceed so that your payments are properly applied to paying down your loan's principal so that you'll know exactly how much to send.
Frequently Asked Questions (FAQs)
Does paying off a car loan help your credit?
Whether paying off a car loan helps your credit depends on your situation. If you're building credit, it may be best to keep the loan for a while. It also helps your credit mix. If you have a high debt-to-income ratio or a high interest rate, it may be best to pay off your car loan early, regardless of its effect on your credit scores.
How do you pay off credit card debt?
To pay off credit card debt, determine how much money you can dedicate to paying down debt each month. Next, decide whether you want to pay down your debt starting with the smallest balance (the debt snowball) or the highest interest rate (the debt avalanche). Then, pay your minimum payments, and apply the extra funds to the debt you want to start with. When that debt is paid off, apply what you've been paying on that card to the next debt.