Paying Off a Loan Early: Is it Worth it?

When you take out a personal loan, you will repay it over an agreed term. However, if you have some money saved up or have come into some extra cash you could choose to repay the loan early.

Paying off a loan early could save you money in the long term as it can reduce the total amount you need to repay. Bear in mind that you need to account for any early repayment charges to help decide if it’s the right choice for you.

Read on to find out more about how you can pay off a loan early, the charges you may face, and whether it’s worth doing.

Can I pay off a loan early?

If your loan is covered by the Consumer Credit Act, as all unsecured personal loans should be, you are allowed to pay it off early.

You could choose to either pay the loan off in full and clear your debt or make an overpayment to pay off some of your outstanding balance.

If you want to pay off your loan in full, you will need to contact your lender for a settlement figure. Once you pay this figure, your debt will be cleared.

The settlement figure will include the cost of the remaining capital left to pay, plus a certain amount of interest and, if applicable, any other charges. How much it costs to pay off a loan early will be explained in your loan agreement and can vary between lenders.

If you want to make an overpayment and pay off just a part of your total loan early, you should be able to do so. However, the way this works will depend on the lender. Some may allow you to make an extra payment online or via their mobile banking app, while others will need you to contact the lender directly to arrange payment.

As with early repayment, how you make an overpayment will depend upon the conditions of the loan, which will be set out in the agreement signed when you took it out.

If you took out the loan less than 14 days ago, you are still in the ‘cooling-off period’. This means you can contact the lender to cancel your loan entirely and, as long as you repay the money you received within the period it specifies, you won’t be charged any extra costs. For example, lenders may give you 30 days to repay the loan after you say you want to cancel the agreement.

What are early repayment charges?

When you repay a loan early, you will typically need to pay a certain amount of interest and, in some cases, a further fee.

Confusingly, some lenders refer to the interest you have to pay when you settle a loan early as an ‘early repayment charge’ while other lenders don’t call it this. Read the terms of your loan agreement to see exactly what charges apply.

The amount you will be charged to repay a loan early often depends on the amount you borrowed and the amount you have left to repay.

Under the Consumer Credit Act, lenders can charge up to 28 days’ interest if your loan term was less than 12 months.

They can charge up to 58 days’ interest if your loan term was for more than 12 months.

In some cases, lenders may be allowed to charge further fees if you make an overpayment or pay off your loan in full.

You shouldn’t be charged a fee if you pay less than £8,000 over the course of 12 months.

However, lenders are allowed to charge further fees if you pay more than £8,000 over 12 months. This applies to single payments of more than £8,000 or if you make multiple payments in a year that add up to more than £8,000.

These fees could be:

• 0.5% of the amount repaid early if there is less than 12 months remaining on your loan agreement.
• 1% of the amount repaid early if your loan agreement has more than 12 months remaining.

Bear in mind that these rules apply to loans taken out from February 2011 onwards.

Why do providers charge early repayment fees?

Providers are allowed to charge these fees because when you take out the loan they calculate the amount of time it will take you to pay back, and the interest it will charge you for doing so. By ending the agreement early, the provider ends up with less money in its pocket, so it can reclaim a little of this through early repayment charges.

Should I pay off a loan early?

Only you can decide if repaying a loan early is the right decision. You should check the terms of your loan agreement to find out how much the lender will charge to clear your debt.

To help you decide what to do, you should consider:

• How much will it cost you? How much interest would you save?
• Could you still afford your everyday expenses and other bills if you paid off your debt?
• Would you have some money left as an emergency fund?
• Do you have any priority debts that need paying off first, such as rent or mortgage payments, energy bills or council tax?
• Do you have any loans, credit cards, or other forms of credit with a higher interest rate? If so, it may make sense to pay these more expensive debts first as you could save you more money in the long term.

If you can comfortably afford to pay off your loan and the money you save on interest is greater than the amount you have to pay in early repayment charges, then it may be worth considering paying off your loan in full.

Bear in mind that, even if you ask for a settlement figure from your lender, there is no obligation to pay it. Typically, you’ll have 28 days to accept the settlement figure. But if you change your mind, you can continue making your regular repayments.

If you can’t afford to pay off your loan in full, you could consider making a partial settlement.

Depending on the lender, paying off some of your loan early could either reduce your future monthly payments or shorten your loan term. Lenders should tell you how a partial settlement will affect your loan. Make sure you factor in the cost of any charges before making any payments.

Does paying off a loan early hurt your credit score?

While paying off a loan early can save you money, it’s worth considering that it could have a temporary effect on your credit score.

Making regular loan repayments until the end of the agreed term can help to improve your credit history as it indicates that you can manage your finances and that you are a responsible borrower.

Paying off a loan early means you will no longer be making these regular payments each month, which could affect your score. It also means your account with the lender will be shorter and so your record of making repayments on time will be smaller.

However, the impact to your score is likely to be minor, especially if you compare it to the effect that missing a payment could have. The benefits of paying off a loan early and the money you’ll save is likely to outweigh any possible impact to your score.

How to pay off a loan early

You need to contact your lender if you want to pay off your loan early.

The lender will provide you with a settlement figure, which is the sum you have to pay to repay your debt in full. This will include your outstanding balance left to pay, plus interest and any fees the lender may charge.

If you decide to go ahead and repay the loan you will need to do this within 28 days of receiving the settlement figure.

How to make an overpayment

If you want to make an overpayment or pay off part of your outstanding loan, you should check with your individual lender for the exact way to do this.

Some lenders will allow you to make an extra payment online or via mobile banking, while other lenders will require you to contact them directly.

Before making the payment, make sure you know if you will need to pay any charges and how the extra payment will affect your loan.

In some cases, an overpayment could reduce your remaining monthly repayments. However, some lenders may keep your monthly payments the same but reduce your loan term.

How else can I save money on a loan?

It may be possible to lower the costs of your personal loan through refinancing or by reducing the term of the loan.

Refinancing to a loan with a lower interest rate

If you’re not able to pay off your loan in full, refinancing to a cheaper loan might be an option. If you can find a personal loan with a lower interest rate, this could work out as a cheaper option for you.

Remember, early loan repayment charges may still apply to the original loan so factor those into your calculations.

» COMPARE: Low-interest personal loans

Reducing the length of the loan

It may be possible to reduce the length of time you’re paying back your loan, which should also mean you pay less interest overall as you pay off your loan quicker. However, your monthly payments would increase as a result.

Speak to your lender and see what your options are. It may agree to shortening the loan, but watch out for changes to your interest rate if it does.

» CALCULATE: Estimate your monthly loan repayments

Can I complain about an early repayment charge?

From personal loans to mortgages, lots of different loans have early repayment charges applied if you clear the debt early. However, these charges need to be ‘fair’.If you think you’re being charged an unfair amount, you have the option to refuse to pay it and to continue with your loan agreement or to complain about the charge, first to your provider and then to the free Financial Ombudsman Service.

Image source: Getty Images