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The word “debt” usually has a negative connotation. Whether it’s student loans, lines of credit, consumer debt or a mortgage, most people strive to pay it off as early as possible. However, there are smart decisions to be made when paying off debt. For example, many people wonder, “Does paying off a loan early hurt credit?” This guide takes you through all the do’s and don’ts of paying off debt early so you can make the right decisions for your financial health.
What are the benefits of paying off debt early?
There are several appealing reasons why you might want to pay off your debt early.
You can save money
When it comes to debt, what can really get you is the interest rates. Luckily, if you pay off a debt earlier, you’re reducing the total interest you pay.
Let’s say you have a credit card balance of $5,000 at an average credit card interest rate of 16 percent. If you’re making a monthly payment of $200, it will take you 31 months to pay off the debt, and you’ll have paid a total of $1,122 in interest.
Now, if you increase your payment, it can make a significant overall difference. By doubling your monthly payment to $400, you will more than double the impact on interest and total loan time. Your time to pay off the debt will decrease to 14 months, and your total interest paid will be $506.
You can protect your credit
If your debt is something like a loan, then paying it off early can protect your credit. You will no longer be in danger of damaging your credit with a late or missing payment. Either of these instances can typically lower your credit score by 90 – 110 points for several months.
Additionally, paying off your debt can help your debt-to-income ratio. Your credit score is made up of five factors, and the debt-to-income ratio accounts for approximately 30 percent of your credit score.
You can decrease your debt-related stress
According to a 2019 survey produced by BlackRock, Americans identify money as their number one source of stress. Debt can make people feel insecure about their future and cause endless worry. This financial stress can start to impact job performance, quality of life and personal relationships. When you pay off your debt early, you’ll have more peace of mind about your financial state.
Potential negative consequences
You might be surprised to learn that there are some potentially negative consequences to paying off debt early as well.
Prepayment penalty fees
It’s essential to read the fine print of your debt before you start paying it off early. Some creditors choose to protect themselves from individuals trying to pay off debt early by including penalty fees. For example, many mortgages put a cap on how much extra you can contribute to your mortgage loan every year. Usually, it’s up to 20 percent of your principal balance annually.
Find out if your loan has a prepayment penalty fee, and calculate whether this fee is greater than the interest left on your loan. If your interest is lower than the penalty fee, it’s really not worth paying off the loan early.
Changes to credit factors
So, does paying off a loan early hurt your credit? The answer is, sometimes it can. For example, installment loans are different from revolving debt. Installment loans, such as mortgages, have a fixed interest rate for a period of time and fixed payments. Revolving debt, such as credit card debt, usually has high interest rates and options for minimum payments.
Keeping installment loans open can help your credit by improving your credit diversity. Additionally, installment loans show the credit scoring companies that you can reliably pay a loan. On the other hand, credit card debt, unless you’re paying it off entirely every month, can do more harm than good to your credit score.
However, this doesn’t necessarily mean that paying off a loan will hurt your credit score—you just shouldn’t expect it to automatically help, either. Your credit score may not change at all, or it may shift in either direction by just a few points.
Paying off debt: Do’s and Don’ts
Do address monthly expenses first
Your debt shouldn’t take priority over your monthly fixed expenses. Payments such as your rent, utilities and food are necessities. You need to pay these to continue living safely and comfortably.
Don’t neglect your savings
It’s crucial to have savings, especially emergency savings. Make sure you have an emergency fund at a level you’re comfortable with. That way, if something urgent comes up, like the loss of a job or a medical bill, you will be able to survive without falling into more debt. People without emergency funds often find themselves turning to desperate solutions (such as payday loans), which are usually more harmful in the long run.
Do consider refinancing
If the balance of your installment debt is incredibly high, it might be time to consider refinancing. This route is usually a great option if you’ve been making regular payments and have seen an improvement in your credit score. A better credit score may mean you qualify for better rates with refinancing, which can save you thousands of dollars in interest.
Talk to a financial planner first to better understand if refinancing is the best option for you.
Don’t discount investment opportunities
It can be tempting to prioritize debt above all else, including retirement. Don’t discount investment opportunities, though. Just as you should have an emergency fund, it can hurt you long term if you don’t begin saving for retirement now.
Additionally, consider the interest rates on your debt. The average return on investments in the stock market is, historically, around 10 percent. If the interest on your debt is lower than 10 percent, investing might be a better option than paying debt off early.
Do consult a professional
The right balance of debt can actually help your overall credit. However, it’s all quite complicated, and there are a lot of different factors to take in. It’s vital to consult a finance professional before making any significant decisions.
Paying off your debt sooner than necessary isn’t quite the straightforward process it might seem to be. There are many factors to consider, and it’s important to be thoughtful before making any decisions. You can also reach out to our team at Lexington Law today to learn more about your credit.
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