Debt. Nearly everyone has it, no one wants it, and most don’t want to talk about it. Debt has become a dirty word in the English vocabulary, and for understandable reasons. It’s natural to think that you should do everything in your power to pay off your loans early whenever possible, but not so fast! While high interest debts like credit cards should be paid off as soon as possible, there are other factors to think about while paying off other types of debt. So if you’re thinking of paying off a loan early, here are a few questions you should answer for yourself first:
1. Do you have an emergency fund?
If you are under a mountain of debt, building a savings account can seem like the least of your worries. However, the U.S. economy is suffering from high unemployment as well as a rise in costs for just about everything. Would you be prepared if you were to lose your job or get sick? Before you decide to pay off a loan early, make sure you at least have some sort of emergency fund first. Some people recommend two months worth of living expenses, but six months is a lot safer. In today’s economy, if you lose your job it could take a half year or even longer to find another one. It won’t help you to pay down debt now if you end up racking up more in an emergency.
2. How much is your interest rate?
There are a lot of types of debt and just as many interest rates charged. Credit cards have notoriously high interest rates – higher than any other type of debt on average. It goes without saying that credit cards should be paid off first, before anything else.
Other types of debt, such as home loans, auto loans, and student loans usually carry lower interest rates. Find out how much money you could save by paying one of these loans off early. The best way to do this is to determine how much extra you can afford to spend. Then calculate the amount of interest you are paying during the life of your loan. How much interest do you save by adding that extra amount to your loan and thus paying it off early. (For help try Bankrate’s mortgage calculator and FinAid’s student loan prepayment calculator.)
Now take that amount of money you would put into extra payments and calculate how much interest you can earn by putting that amount into a CD or other high yield savings account. If the amount you’d earn in one of these is higher than you’d pay, then maybe you’re better off doing that and then applying the money earned to the loan later (which is not likely at this time, since interest on savings accounts and CDs is quite low!)
Note: if you are a savvy investor, you could potentially earn more money by investing the extra money into the stock market. This is highly risky, however, and should only be considered if (A) you understand the stock market very well, and (B) you are willing to risk losing the money you invest in case your stocks don’t fare well. See our article, Is It Better to Invest or Pay Off Debt? for a more detailed explanation of this question.
3. Are there penalties for paying off your loan early?
Let’s say you’ve done the math and learned that the money you’ll pay in interest for the lifetime of your loan is higher than what you can earn elsewhere. You should then allocate the extra money to pay off your loans early. But there’s one thing to watch out for. Some lenders charge a fee for early repayment of a loan. To find out if you could get hit with these fees, just go back to the paperwork you signed upon loan origination and comb the fine print for prepayment fees. If there are fees, are there ways you can get around them? Will these fees equal more or less than the total interest saved by paying your loan off early?
4. How will paying off your loan early affect your taxes?
We’ve already done a lot of math, but there’s one more calculation for you to make: taxes. Are you using your loan as a deduction on your taxes? If it’s a student loan or mortgage, you probably are. Any other loans are probably not eligible for tax deduction unless you are using them for work. The easiest thing to do is talk to your tax preparer and find out if the money saved by these tax deductions is more or less than the money spent on interest during the original life of the loan.
5. Which types of loans should you pay off early?
Should I Pay Off Credit Cards Early?
Credit cards are the only type of loan that unquestionably should be paid off early. There is no predetermined life to these loans and paying just the minimum payment could have disastrous effects on your finances. The minimum payment is only a tiny percentage of your balance and anything paid over the minimum goes straight to your principal balance.
Do you want to have a clear picture of just how much money you lose by paying minimum payments only? Check out this Credit Card Debt Calculator. Alternatively, look at the top of the first page of your credit card statement. Issuers are now required to give you a minimum payment warning and some even show you how long it will take you to pay off your card while just making minimum payments. After you recover from your shock at the repayment term and the amount of money it ends up costing overall, remember that it doesn’t even include future purchases and balances added to your card.
What this means is, since credit card interest rates are usually higher than other types of loans, you should almost always pay them off early if possible.
Should I Pay Off Secured Loans Like Mortgages and Car Loans Early?
Secured loans are loans that have collateral attached to them, such as mortgages and car loans. Lenders often charge lower interest rates on these since they can reclaim the collateral if you default. Still, there are options to help you reduce the life of these loans and save money on interest.
One relatively painless option is to sign up for bi-weekly payments, which can work especially well if you get paid on a bi-weekly basis. Here’s how it works: rather than paying one lump sum each month, you pay half of your payment every two weeks. For example, if you owe $1000 per month on your mortgage, you’d pay $500 every two weeks. This causes you to make 26 payments per year (or 13 full payments rather than 12). That’s one full extra payment per year! The extra payment goes directly to your principal and can significantly cut down the life of your loan. What’s the best thing about this option? You don’t feel like you’re paying any more money than you’re already used to paying – although you’re paying it at different times than you’re used to. Some people even find that having one payment due around the time of each paycheck actually helps them budget.
How do you sign up for bi-weekly payments? Contact your lender and see if they offer them. Some don’t offer them at all, or charge a fee if they do. This fee usually includes an up front cost as well as a charge each month. There are also third party companies that offer this. Either way, if someone’s going to charge you then it’s probably not a good idea. It doesn’t make any sense to pay a fee if you’re trying to save money in the first place. Another option would simply be to pay one extra time per year or pay an extra 1/12 of your monthly payment each month.
Should I Pay Off Student Loans Early?
If you’re juggling several types of debt, you will not want to pay off your student loans early, because your other debts will usually have higher interest rates. To better manage several different types of debt, you might even want to try a plan like income based repayment, which can lower your monthly student loan payments (thereby allowing you to pay more toward your other debts like credit cards). In order to qualify for IBR, contact your student loan lender directly. [Be aware that the downside of IBR is you could pay more interest overall because you’re extending the life of the loan and you’ll have to stay on top of your annual paperwork or you could end up incurring major fees].
Another consideration when deciding whether to pay off your student loans early is whether you qualify for public service loan forgiveness. If you do, then it won’t make sense to pay the loan(s) off early. Public service loan forgiveness is available for people who are employed by nonprofit organizations, the government (including the military and public schools), Americorps, and Peace Corps. So how does this work? Basically, if you work full-time in a public service job for 10 years (and pay 120 payments) then your debt will be forgiven. You can use this plan in conjunction with income based repayment or income contingent repayment. For more information, check out this article in US News or IBRinfo.org.
So, should you pay off your loan early? As you can see now, there are many factors to consider before making a final decision. Once you have an emergency fund set aside, then just consider which debt is costing you the most money at the end of the day. This means anything with higher interest (especially credit cards) should be paid off first. And if you earn more money on tax deductions or interest earned in investments than you pay out on interest for your loans, you may want to consider keeping the loans. In summary, let the math work for you (rather than the other way around)! If you make informed decisions about how to pay off your loans, you’ll be on the road to a solid financial future.