What happens if you pay off a personal loan early? (2024)

When it comes to paying down debt, you might have heard that paying off your balance as quickly as possible can help you save money in the long run. And this is often the case. If you pay off your credit card balance in full, for example, you'll save on interest charges.

Generally, the longer you're stuck paying back a loan or other debt, the more you'll pay in interest over the lifetime of the loan. So it seems obvious that paying off your personal loan early would be a good idea — but not so fast.

Below, CNBC Select breaks down why personal loans are different from other types of debt and how paying one off early can impact your credit score and your finances.

There are an abundance of financial products out there when you need money to pay for something. And each is a little different, so it's practically impossible to have a one-size-fits-all approach to debt payoff. You'll want to consider things like interest rates, billing cycles, loan terms and any fees as you make your plan.

Student loans are used for paying tuition and other costs associated with an education. Car loans are meant for helping you purchase a vehicle. Personal loans can be used for pretty much any expense — a wedding, a home renovation, a vacation and even debt consolidation. While you may need to explain how you plan to use the money on your application, there generally isn't a hard and fast rule about how you use your personal loan.

Like a car loan or a student loan, you'll receive a lump sum of money that you need to repay in monthly installments over a fixed period of time (known as the loan's term) along with interest charges.

The repayment period for a personal loan can be anywhere from two to five years, but some are as long as seven years. Car loans are generally six years long on average, while student loans typically have a 10-year timeline, but it could take longer if you're on an income-driven repayment plan.

Personal loans are different from credit cards because there is no set timeframe for paying back your credit card debt, though, the quicker you pay off the balance the less you'll accrue in interest charges. (Ideally, you pay off your balance on time each month and never pay interest.) Credit cards also have a credit limit, which is usually much smaller compared to the average personal loan amount that borrowers request.

While the interest rate on personal loans is generally much lower than that of credit cards, it really depends on how much money you request and your credit score. Keep in mind that the higher your credit score, the more favorable your terms can be; a good credit score will help you get approved for a lower interest rate or a longer loan term or both.

Sometimes, personal loans come with a few additional fees, including an origination fee and a prepayment penalty. It's the early pay-off fee you need to be wary of.

It is possible to pay off your personal loan early, but you may not want to. Making an extra payment each month or putting some, or all, of a cash windfall, toward your loans, could help you shave a few months off your repayment period. However, some lenders may charge a prepayment penalty fee for paying the loan off early.

The prepayment penalty might be calculated as a percentage of your loan balance, or as an amount that reflects how much the lender would lose in interest if you repay the balance before the end of the loan term. The calculation method will vary from lender to lender, but any prepayment penalties would be outlined in your loan agreement.

There are a number of lenders that don't charge a prepayment penalty. SoFi, for example, won't charge you a prepayment fee for paying off the loan early and there's also no late payment fees. If you'd prefer looking into a peer-to-peer lender, LendingClub is another option for loans with no prepayment fee. Typically, you'll need good to excellent credit to qualify for the best personal loans with the best terms.

When you pay down your credit card balance, you lower the amount of credit card debt you have in relation to your total credit limit. This means your utilization rate, which makes up 30% of your credit score, is lowered and it can help you give your credit score a little boost. So shouldn't the same be true when paying off your personal loan?

According to Experian, personal loans don't operate the same way because they are installment debt. Credit card debt, on the other hand, is revolving debt, which means there's no set repayment period and you can borrow more money up to your credit limit as you make payments. Installment debt is a form of credit that requires you to repay the amount in regular, equal amounts within a fixed period of time. When you're done repaying the loan, the account is closed.

When you take on a personal loan, you add to the number of open accounts on your credit report. The loan can also improve your credit mix, which makes up 10% of your FICO score. But when you pay off an installment loan, it appears as a closed account on your credit report. Closed accounts aren't weighted as heavily as open accounts when calculating your FICO score, so once you pay off your personal loan, you'll have fewer open accounts on your credit report.

If you pay off the personal loan earlier than your loan term, your credit report will reflect a shorter account lifetime. Your credit history length accounts for 15% of your FICO score and is calculated as the average age of all of your accounts. Generally, the longer your credit history, the better your credit score will be. Therefore, if you pay off a personal loan early, you could bring down your average credit history length and your credit score. How much of a change in your credit score will depend on your overall credit profile.

Having a low credit score can put you at a disadvantage making it difficult to get an apartment, good financial products, even a job. However, practicing good financial habits, like making consistent, on-time payments and avoiding applying for too many new lines of credit at the same time, can help boost your score.

Subscribe to the CNBC Select Newsletter!

Money matters —so make the most of it. Get expert tips, strategies, news and everything else you need to maximize your money, right to your inbox.Sign up here.

Personal loans can be a convenient and affordable way to cover a large expense and improve your credit history when used responsibly. But as with any financial tool, you should carefully consider whether your circ*mstances will allow you to get the most benefit from a personal loan. Paying off the loan early can put you in a situation where you must pay a prepayment penalty, potentially undoing any money you'd save on interest, and it can also impact your credit history.

If you think there's a possibility that you'll want to pay off the loan sooner than the terms require, you should consider submitting an application to a lender that won't charge a prepayment penalty. Always do your research and read the terms and conditions before signing up for a new financial product so you clearly understand what to expect.

Read more