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What Happens If I Pay Off a Loan Early?

While settling loans ahead of schedule can save on interest, it's crucial to consider potential early repayment charges and other factors before making a decision.

When your finances improve, you may find yourself able to pay off an instalment loan faster than originally scheduled. Paying loans off early seems like a smart money-saving strategy, potentially saving you money on interest costs. But what happens when you repay a loan ahead of schedule?

While there are certainly benefits to settling a loan early, you may have to pay an early repayment charge, overpayment fee or prepayment fee. Depending on various factors, such as the outstanding balance and the remaining loan term, this can significantly decrease the amount you save in interest. If you’re considering early repayment of loans, read the terms and conditions carefully before making a decision.

Key Takeaways:

  • Paying loans off faster can help you save on interest, but sometimes carries early repayment penalties.
  • Short-term debts with high interest rates, such as payday loans and credit card debts, typically benefit most from early repayment.
  • Loans for business use, secured loans (e.g. mortgages) and long-term personal loans are most likely to come with early repayment fees.
  • If you have multiple non-priority loans, consolidating your debts can streamline and optimise the repayment process.
  • Always weigh up the potential savings against any fees and charges before repaying a loan early. Seek professional debt advice if necessary.

How Does the Early Loan Repayment Process Work?

Making additional payments beyond your regular monthly loan payment reduces your outstanding principal balance faster, which cuts down the total interest paid over the remaining loan term. Lenders typically apply any extra payment amount to the current month’s balance first, with the remainder being used to reduce the principal.
Most loans can be partially or fully paid off ahead of the original schedule. Full early repayment closes the loan completely, with no remaining balance or payments outstanding. Partial payments typically work in one of two ways:

  • Lowering your regular monthly payment amount, so you pay less each month for the duration of the loan, or
  • Reducing the loan term, so you continue making your usual repayments but over a shorter period (thereby paying off the loan early).

However, overpaying without contacting your lender first may mean they simply advance your next due payment date forward, rather than applying the overage to principal reduction. Clear communication is key to avoid confusion.

Also, keep in mind that there may be some restrictions on the frequency or the amount of any overpayments you can make. Repaying a loan earlier than agreed may come with fees or penalties.

What Are the Benefits of Paying Off a Loan Early?

Paying loans off faster than the original scheduled terms can be advantageous in many cases. Some of the potential benefits include:

01. Paying Less Interest

By paying down the loan principal balance faster, less interest accrues over the remaining length of the loan. This accelerated principal reduction can result in substantial savings on the total interest paid over the life of the loan.

02. Freeing Up Cash Flow

Since the principal balance is reduced, the number of months remaining on the loan repayment term also shortens, meaning you become debt-free sooner. Alternatively, you could choose for your regular monthly payment amount to be lowered.

Either way, making early repayments frees up monthly cash flow that was going toward the loan, allowing you to redirect the funds to other financial goals (such as savings).

03. Faster Return on Investment

For assets like vehicles that were financed, paying off the loan early means you achieve full ownership sooner. This allows you to enjoy the benefits and use of that asset ahead of schedule, and potentially sell it earlier than planned for a faster return on investment.

04. Peace of Mind

For some borrowers, the emotional benefits and reduced stress of becoming debt free provides a valuable boost to their wellbeing. Reaching a zero balance and settling your loan sooner than originally planned can provide valuable peace of mind above and beyond the financial savings.

05. When Early Repayment Benefits Most

For high-interest loans like credit cards, payday loans or short 1-5 year financing, early repayment often makes the most financial sense, allowing you to substantially reduce expensive interest costs. However, it’s important to evaluate your own specific loans to gauge the potential interest savings from accelerated repayment.

Are There Any Downsides of Early Loan Repayment?

While it often makes financial sense to pay off a loan early, fully, or partially repaying loans faster than the original repayment agreement can also come with some downsides. For example:

01. Early Repayment Charges

Some loans, especially mortgages, come with early repayment charges or overpayment fees. These are fees that you might have to pay if you repay all or part of your loan earlier than the agreed term.

These extra fees can eat into interest savings, so it’s essential to check the terms of your loan agreement to see if these apply. There are scenarios where accelerated repayment can cost you more, depending on your specific circumstances.

02. Lost Tax Benefits

In some cases, the interest on certain loans (such as business loans, buy-to-let mortgages and investment loans) might be tax-deductible. By paying off the loan early, you could lose out on these potential tax benefits.

03. Opportunity Cost

The money used to pay off the loan early could have been invested elsewhere, potentially earning a higher return.

For instance, if the interest rate on your loan is lower than the potential return on an investment, it might make more financial sense to invest the money rather than using it to repay the loan early.

04. Impact on Credit Score

While paying off a loan can positively impact your credit score, closing an account can reduce the age of your credit history. This might have a short-term negative effect on your credit rating. It might also reduce the amount of variation in your ‘credit mix’, which could also impact your score.

05. Loss of Flexibility

Funding lump sum repayments requires giving up a large amount of cash. Once you’ve made extra payments towards your loan, you can’t easily access that money again. Using a significant portion of your savings to pay off a loan early might leave you with less money available for emergencies, for example.

Which Types of Loans Have Early Repayment Fees?

Certain types of loans are more likely than others to impose early repayment charges (ERCs) or overpayment fees if you repay them faster than the original term. These include:

01. Mortgages

Most fixed-rate mortgages, as well as some tracker mortgages, have clauses that charge penalties for repaying more than 10-20% extra per year. If you’re on a fixed-rate deal, you’re more likely to face an ERC if you want to overpay or repay the entire mortgage during the fixed term. Always verify if your mortgage contract includes these early repayment or redemption fees.

02. Business and Commercial Loans

Some business loans, especially long-term ones or those with fixed interest rates, might have early repayment charges. Loans funding large business investments or commercial real estate often have such penalties written into the contract to ensure the lending institution profits over a predefined period.

03. Car Finance

Early repayment fees are very common with car financing, including both hire purchase (HP) and personal contract purchase (PCP). This fee can vary depending on the provider, but is typically calculated based on 1-2 months’ worth of interest.

04. Personal Loans

Outright early payment penalties or fees are uncommon from most major personal loan lenders in the UK. However, it’s advisable to carefully check your loan agreement for any special stipulations just in case.

Always compare potential interest savings against any applicable penalties before deciding to repay your loan early. The idea is to maximise your overall financial benefit.

How Can I Avoid Early Repayment Penalties?

If you find yourself faced with prepayment penalties on a specific existing loan, here are some steps you can take to try to mitigate or minimise the fees:

  • Speak to Your Lender: Initiate a conversation with your lender to discuss the possibility of waiving or reducing the early repayment penalty. They might be willing to negotiate, especially if you have a good repayment history or if they believe there's a risk you might default.
  • Overpayment Allowance: Many loan agreements allow borrowers to overpay a certain amount each year without incurring penalties. Check if your loan has such an allowance and, if so, stay within that limit.
  • Wait Out the Penalty Period: If your loan has a specific period during which early repayment penalties apply (e.g., during the fixed-rate period of a mortgage), consider waiting until this period is over before making significant overpayments or paying off the loan.
  • Consider Refinancing: If you're considering refinancing or consolidating to take advantage of lower interest rates, ensure that the savings from the new loan outweigh any early repayment penalties from the old loan.

Go through the terms and conditions of your loan agreement to understand the specifics of any early repayment charges. Remember, communication is key: being transparent with your lender about your intentions and reasons for early repayment can open avenues for negotiation and understanding.

What Should I Consider Before Repaying a Loan Early?

Whether aggressively accelerating debt repayment is advantageous or not depends on several factors:

  • The remaining length of the loan term – longer terms generally have greater interest savings potential.
  • The interest rate on the loan – the higher the rate, the larger your potential savings from early payoff.
  • Applicable early repayment penalties – weigh these penalties against projected interest savings, as well as the value of any lost tax benefits.
  • Other investment opportunities – repayment funds could potentially earn higher returns if invested wisely elsewhere long-term.

It is wise to carefully run the numbers and projections for your specific debts and financial situation. While paying off high interest, short 1-5 year loan debt early almost always makes strong financial sense, long-term low rate assets like mortgages may actually benefit more from investing extra funds instead.

Should I Consolidate Debts Before Making Extra Payments?

If you currently have multiple outstanding instalment loans, credit cards, or lines of credit, consolidating them into a single new consolidated loan may benefit you by:

  • Simplifying multiple repayments into just one lower monthly amount.
  • Providing a fixed repayment term, allowing you to know exactly when you'll be debt-free.
  • Potentially offering a lower interest rate than the rate on your current individual debts.
  • Allowing you to redirect all repayment funds into one centralised loan balance.
  • Providing more flexibility than closed-end instalment loans if your financial circumstances change.

Consolidating your debt through a consolidation loan first could help you optimise and accelerate your loan repayment process. Just be aware that if the loan term is extended significantly, you might end up paying more in interest over time.

Can Consolidation Help Me Avoid Early Repayment Penalties?

If you’re considering a consolidation loan to avoid early repayment penalties on an existing loan, it’s essential to do the maths.

Determine the total cost of the early repayment penalty and compare this to the potential savings from the consolidation loan (considering interest rates, fees, and loan term). If the savings from consolidating outweigh the early repayment penalty, it might be worth proceeding.

Always read the fine print of any consolidation loan agreement and consider seeking advice to ensure it’s the right move for your specific situation.

Explore Your Options with Consolidation Expert

Paying off loans earlier than required could result in substantial savings. However, you should consider any potential early repayment penalties and other drawbacks before you come to a decision. You should be sure that paying off your loans early aligns with and supports your overall financial goals.

If you feel weighed down by multiple debts and want guidance on managing them, Consolidation Expert can help. Our lending panel may be able to provide the ideal consolidation loan for your unique situation, with interest rates, and repayment terms that suit you. Apply online today to explore your options.

Representative 14.8% APR

We are a broker, not a lender.

Representative Example: Borrowing £15,000 over 60 months, repaying £355.28 per month, total repayable £21,316.57.

Total cost of credit £6,316.57.

Interest rate 14.8% (variable).

The lenders on our panel offer loans for 12-360 months, with rates from 4.7% APR to 42.6% APR.

The Representative Example is based on all loans paid out by lenders between 1st Jan 2022 and 31st Dec 2022.

Further reading

Read Is it Possible to Consolidate Short-Term Same Day Loans?
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Read Can I Consolidate Holiday Loans with Other Debts?
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Read How Can I Pay Off My Debts Faster?
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