Does it Make Sense to Pay Off Loans Early?

January 7, 2021

Does it Make Sense to Pay Off Loans Early?

As people’s finances change dramatically due to economic uncertainty, they are looking at savings and debt in a new way. Many people are developing an aversion to any kind of debt. However, in some cases, debt is a helpful instrument, and there are benefits to borrowing money at low rates.

Pay Later: Low Interest Rates Make It Advantageous to Keep Borrowing Money

In many cases, it is worth it to borrow the money and not pay it back early. This is true even if you have the ability to do so. The key is to take a look at the interest rate on your loans. Even if you have a higher interest rate, you may have the ability to refinance your loan to a more reasonable one.

Interest rates are at an all-time low right now. Some of your loans may have rates that are so low that it actually makes sense to pay the interest.

Let us hypothetically assume that you have a loan with a 5% interest rate. You may be able to invest the money and earn an 8% return. Thus, you are leaving 3% on the table if you pay off the loan early.

Pay Later: You May Not Want to Lose the Tax Benefits

Moreover, some loans have tax benefits on the interest payment. For example, if you meet the income criteria, you can receive a tax deduction for the student loan interest that you pay. The same holds true for mortgage interests up to a certain amount. Thus, the interest rate that you end up paying after factoring in the tax deduction is much lower. Accordingly, it makes perfect sense to leave this loan outstanding and pay off the amounts as they are due.

Pay Earlier: Early Loan Payoff Can Help Your Credit Score

There are some considerations that are in favor of the prepayment of loans. The first way that early payoff will help you is by improving your credit score. The credit bureaus will look at your overall debt levels in computing your score. Lowering your debt will help your utilization, which is one factor in your credit score.

Pay Earlier: You Want to Avoid High Interest Rates

If you have a high interest rate and have difficult refinancing, it also makes sense to pay your loans off early. The interest expense can add up quickly, and you are saving yourself a great deal of money if you can at least cut it by a little. If your interest rate exceeds the rate of return that you can get from investing the money, you should consider an early payoff.

In addition, you may not have the best discipline to save the extra money that you would use to make an early payoff. If you do not trust yourself to do the right thing with the money, putting it towards an extra loan payment is a good way to make sure that you use the money properly.

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