Why Pay Off Loans Early?
Benefits of Reducing Debt
When you have extra money available, paying off debt is often 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.
For now, we’ll focus on the benefits of debt reduction, but you should also be aware of some potential drawbacks of paying loans off early.
Save Money by Paying Off Loans
The best reason to pay off debt early is to save money and stop paying interest. Interest charges don’t buy you anything except the ability to pay slowly. 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.
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 the minimum is a bad idea.
Over your lifetime, you'll keep more of what you earn if you pay off loans quickly.
So, what's the tradeoff? When you pay down debt, you can’t use your extra money for other things. That might mean you enjoy fewer luxuries in your monthly budget, or you make do with a smaller cash cushion (making it harder to pay unexpected expenses). What's more, you pay an opportunity cost: You'll have to come up with additional funds to put toward other goals (retirement or a down payment on a house, for example).
In rare cases, you don’t save by repaying early because the costs are already baked into your loan. For example, you benefit less from prepaying "precomputed" loans—but you still eliminate the monthly payment.
Save for the future: 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. Hopefully, you redirect those funds toward other goals. For example, when you pay off an auto loan, you can put the previous monthly payment into savings or pay off other debts.
Improved ratios: 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 debt to income ratios and are more likely to get approved for a new loan on favorable terms.
Better credit: Your credit scores can also 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 could potentially 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. For more details, see how your credit limits affect your credit.
Peace of Mind
Eliminating debt can be rewarding and reduce stress. In fact, 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.
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 credited to your account (reducing the loan balance, instead of counting as early payments), and so that you know exactly how much to send.