Does Paying Off a Loan Early Hurt Your Credit?

Nobody wants to take out a loan. In a perfect world, the cash available to be able to make the purchases we want to make. Unfortunately, life doesn’t work that way. For most of us, the reality is that we often have to take out loans for more significant expenses in our lives.

Whether it’s to help pay for a car, for a house, for education, to make next month’s rent, there is a myriad of different ways that we end up taking out a loan.

When we do take out a loan (for whatever the reason), there are a string of terms and conditions that are attached to it which range from the interest rate to the monthly repayment amount, to the duration of the loan, and many more. It’s this last term in the loan contract which we will focus on in this article – the length of the loan.

What is a Loan Term?

The ‘term’ is business jargon for the length of the loan. If you have a two-year term, then you will make monthly repayments to the lending institution for two years, and then the loan will be fully repaid. On day one, you will receive cash in the amount of principal that you requested in your application, and you will have a liability for the next two years of the remaining balance of the loan.

When you take out no credit check title loans or any type of loan, you want the repayment period to be as short as possible. The longer that you borrow money for, the more interest you will end up paying. Nobody likes paying interest – but banks and lenders love receiving interest payments. This is how they make their money.

Sometimes though, you are forced to extend the term of the loan because you need to make the monthly repayments low enough that you can afford them. This isn’t ideal, but at least you were able to get the loan and can use it for whatever payment you needed to make.

What Happens When Your Financial Situation Changes? 

Maybe you managed to get another job that paid better, for example. This is a great situation to find yourself in. You know that you are paying too much away in interest on your loan and your basic instinct, which is correct, is to use your money to pay off your loan early.

However, while your instinct is correct, you need to be extremely careful here. You may get hurt for paying off your loan early. There may be penalties and extra fees which you will incur for doing so.

How Do You Know If You Will Be Punished for Your Good Behavior?

This is where you need to take a look at your loan agreement and look for a section on early or pre-payments. Lenders can legally add a clause to your contract which states that, in the case of the borrower paying off the remaining balance on a loan early, the borrower will incur a fee.

Why Would Lending Institutions Have Early Payment Penalties?

Unfortunately, this is not the case. They are quite happy with you owing them money. This is because, as we said earlier, the longer you owe them money, the more interest you are paying to them.  Consequently, they want to essentially get reimbursed for the interest revenue that they are missing out on by your early payment.

It’s important to note here that this is not necessarily standard policy across all personal loans. There are many variations across lenders. Some won’t charge a fee at all. Others will charge fees based on a percentage of the loan that is outstanding or based on the amount of interest that is left to pay. As always, it is crucial to check out these details in your loan agreement before you sign it as it can have material impacts on your financial situation down the line.

Will Paying a Loan off Early Affect Your Credit Score? 

Before you pay off your loan early and potentially pay a fee for doing so, you should think about the potential adverse impact this action can have on your credit score. One of the mechanisms for increasing your credit score is to have multiple open and active accounts. By paying off your loan early, you will be closing one of these accounts, and this will result in a short-term decrease in your credit score.

Knowing this, think about whether or not you might need access to credit again any time soon. Your lower credit score might make it harder to obtain another loan, or you may get worse terms as a result. These negative consequences, in addition to the pre-payment fee, might mean that it is better to keep making the payments on your current loan.