Paying Off Your Loans Early: Everything You Need to Know

For some people, taking out a loan can be a necessary step to achieve financial goals, whether it's buying a car, constructing a house, starting a business, or paying for education. 

When you take any loan, you know it is a risk, and you must carefully plan how to repay it. So that will likely become your topic financial priority. After all, paying interest is expensive, and the burden of being in debt isn't fun.

It is not strange to think you'd want to clear the loan first if an opportunity presents itself. The idea of gaining financial freedom and eliminating debt stress is undeniably enticing. But is it the right decision for everyone? 

Many individuals seek to expedite their loan repayment process and liberate themselves from the shackles of debt by making early repayment. But before you do that, you must know how the process works and what you stand to lose or gain.

This article will explore early loan repayment and how it works, your options, and whether it is a good or bad idea. 

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Early Loan Repayment: What it Entails

Early loan repayment involves repaying all or part of your loan (in larger installments than agreed) before the end of your credit agreement. 

At the outset of any loan, you will typically agree with your lender on the loan term and how you will service it. Depending on your lender and the type of loan, this will involve repaying the loan on or before a specific date or in installments over a specified period and interval. 

The credit agreement you sign when taking out a loan usually has a section that sets forth early repayment conditions. It highlights what happens when you repay your loan before its maturity. 

Some lenders will let you pay off your loan ahead of time, and others won’t. Some lenders allow early payments without penalty, while others will charge you an early repayment penalty. Most lenders want you to stick to the credit agreement and service your debt as agreed. 

When you take out a loan, different circumstances might make you consider repaying your it early. You may want to reduce your loan burden, lower your debt-to-income ratio to qualify for a new loan, or simply save money on paying interest. But before you make an early repayment, call your lender and check your loan agreement to find out if they charge a prepayment fee. 

Depending on the type of loan you took, a lender might receive less money in interest if you make an early repayment. Therefore, some lenders will charge you an early prepayment fee to recoup some of the interest you would’ve paid if you continued to the full length of the agreement. This fee is called a prepayment penalty.

With that in mind, what are some of the early repayment options available to you?

1. Allowed with no penalties: Some lenders will allow you to make larger repayments or cover your remaining loan balance with a lump sum payment without charging you any prepayment fees. Most lenders who allow this option calculate interest using the reducing balance method, where you pay interest only on the outstanding principal balance. If you have a reducing balance loan, you can save money on interest by paying your loan early and face no penalties.
2. Allowed but at a fee: Some lenders will charge you a prepayment penalty if you defer from your original loan agreement by making an early repayment. The size of your penalty will vary depending on the conditions of your loan contract. The early repayment fee can be calculated in two ways: 

• Flat Fixed Amount: In this method, the lender specifies a fixed amount you must pay as a penalty for early repayment. For example, the loan agreement may state an early repayment fee of Ksh5,000 per loan. Regardless of the remaining loan balance or interest, you would be required to pay this fixed amount if you choose to repay the loan early.
• Percentage of Remaining Interest: Alternatively, the early repayment fee can be calculated as a percentage of the remaining interest that would have been paid if you stuck to the loan agreement. For instance, you would need to pay 10% of the interest that would have been paid if the loan had reached its full term.

3. Not allowed: Some loan agreements may not allow early repayment at all. In this case, if you want to pay off the loan before the original tenure, you would be required to pay the entire interest amount along with the principal as if they had kept the loan for the entire duration. Essentially, you are obligated to fulfill the original loan agreement.

Should you pay off your loan early? That will depend on your financial situation and the terms of your loan agreement. Sometimes, it can save you money, but even then, you must consider the opportunity cost.

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Does Early Loan Repayment Save You Money?

Can you save money when you pay off your loans early? That will depend on three things. 

1. The Type of Your Loan

Some types of loans favor early repayments, while others don’t. Repaying a credit card debt early can help you save money on interest. Paying off a short-term loan with predetermined interest, such as a digital loan, doesn’t save your money, but they have other benefits like reducing your debt burden (DTI) and giving you peace of mind. 

On the other hand, long-term personal loans, business loans, and other types of secured loans will charge you a prepayment penalty if you repay your outstanding loan balance before maturity. How much you will be charged will depend on the credit agreement and your lender.

Early loan repayments also have effects on your credit rating. Repaying revolving credit like credit cards early can improve your credit score. However, repaying a long-term loan early affect your credit age, and you will miss the opportunity to build a positive credit history by making consistent on-time payments. Your credit ratings might not get the boost it would get if you stuck to the original repayment plan.

2. The Terms of Your Loan 

If the lender imposes no prepayment penalties, you can benefit from paying off your loan sooner. Even if there is a prepayment fee, you could save money if the penalty is lower than the interest you would pay if you stick to the original loan agreement. 

For instance, if your lender charges a flat fee of Ksh10,000 but the remaining interest you will pay if your stick to the loan agreement is Ksh20,000; early repayment will save you money. To determine whether paying off your loan early is a wise decision, you should carefully consider the trade-off between the early repayment fees you'll incur and the interest savings you'll achieve.

Read Also: How Do I Decide Whether to Take a Loan or Not?

3. Your Financial Situation 

Will paying off a loan earlier expose you to financial troubles/instability? Before paying off a loan, you need to consider if you have an emergency fund. If you pay off a  loan early and don't have a safety net, you may need to borrow if you have unexpected expenses. Those emergency loans might have a higher interest rate. 

Secondly, think about opportunity cost. This is the amount of potential gain you miss out on when you spend your money repaying a loan instead of investing it. In other words, could investing that money yield higher returns? 

Before making early repayment, assess the potential returns from your investment options and compare them with the interest rate on your loan to calculate the opportunity cost. If early repayment doesn't save you money, consider sticking to the original repayment plan and investing your money.

Lastly, consider whether early loan repayment will jeopardise other financial goals. If you have limited funds and other financial priorities, such as saving for retirement or other long-term goals, it may be more beneficial to prioritise those objectives instead of paying off the loan early.

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When Does Early Loan Repayment Make Sense 

When you want to lower your DTI to qualify for another loan: Lender will typically consider your DTI before lending you money. Early repayments might benefit if you plan to take on a loan and think your current loans might affect your qualification chances. Additionally, you can't escape early repayments if you are borrowing a debt consolidation loan or refinancing a specific loan.

When you want to improve your cash flow: Cash flow difficulties frequently arise when your expenditures match or surpass your earnings. By prioritizing the repayment of specific debts, you can decrease your monthly expenses and enhance your cash flow since debt repayments can substantially inflate your expenses. This will make it easier to manage your money and grow your savings.  However, ensure you have an emergency fund, as it can come in handy when you have unexpected expenses. It will prevent reliance on costly borrowing.

When you can afford the prepayment fee and want to be debt free: Before making early repayment, it is crucial to ensure you can save money by doing it. You can consider it if you have done the math and found it cheaper to repay your loans before maturity. But you should only do this if your goal is to be debt free and you have factored in the opportunity cost. 

When you want to eliminate the risk of variable rates loan increasing over time: In this type of interest on the outstanding balance changes based on market interest rates. When rates go up, the cost of your loan will go up. If interest is increasing, you can consider making an early repayment if it is cheaper.

Read Also: Things to Consider Before Taking a Personal Loan in Kenya

WRAPPING UP

When taking a loan, it is important to consider the prepayment penalty and discuss it with your lender. When borrowing money, it is common to think about early loan closure. However, sometimes, it might not be as easy as you think. And even if you don't plan to make an early repayment, having the option of clearing your debt early is enough to give you peace of mind.

Whether paying off a loan early is a good idea will depend on your financial situation, how much interest you have left to pay, and the prepayment penalty you may face to clear the debt before the end of the term.

If you are thinking of early repayment, it is always worth contacting your lender directly and asking them how much it will cost you before you do it.