Wise choice of bread
Debt stinks. We all know this. The smart move here would be to pay off all debts as soon as possible, right? Not so fast. In some cases, paying off your debt early won’t save you that much money. Let’s take a look at the pros and cons of paying off debt before you have to.
Pros: You will save thousands of dollars in interest
You cannot take out a loan without paying interest. You also cannot carry a credit card balance without paying interest. And the longer you owe money, the more interest you will pay. Let’s say you buy a car for $25,000 and borrow $20,000 at a 3 percent interest rate on a 60-month loan. This could mean paying more than $1,500 in interest over five years. What a waste, right?
So, whether it’s an auto loan or credit card debt, the sooner you pay it off, the more money you’ll save on interest payments, and depending on your balance, that can mean hundreds or even thousands of dollars. (See also: 15 tips from people who have paid off an incredible amount of debt)
Cons: You may have already paid off most of the interest on the loan.
Most loans have what’s called a “repayment schedule” that tells you how much you’ll pay in interest and how much you’ll pay in principal each month. With many loans, especially mortgages, you pay most of the interest in the early years and then most of the principal.
For example, let’s say you have a 30-year loan of $300,000 with an interest rate of 5 percent. Using this handy depreciation calculator, that means you’ll be paying $1,610 per month. (For simplicity, I exclude taxes and insurance in this calculation.) A typical depreciation schedule shows that you will initially pay $1,250 per month in interest payments. But by the end of the loan period, your interest payments are much lower. By the time you have three years left on the loan, you will be paying a little over $200 in interest per month, and it will continue to drop from there.
If you repay the loan rather late, paying off the loan early has little financial advantage. At this point, you are practically borrowing money interest-free, so you can keep your cash or use it for something else. (See also: 5 Debt Management Questions You’re Afraid to Ask)
Pros: You free up money for other things
Your mortgage is $1,500 per month. The car fee is $200 per month. Your student loan payment is $180. The minimum payment on your credit card balance is $250. If you are tied to these payments every month, you may not have much money left for other needs or desires. Debt prevents you from having true financial flexibility. Pay off those debts early and breathe easy knowing you’ve freed up a significant amount of money.
Cons: You can run out of your reserve fund
Your desire to pay off your debt early may be strong, but where does this money come from? For example, it is not easy for most people to pay off the $20,000 left on their mortgage in one fell swoop. If you have that much cash on hand, you need to make sure it doesn’t come from your reserve fund. Paying off your debt can be nice, but when you don’t have the money left to cover a medical emergency or job loss, you’re playing a dangerous game. It’s best to have at least three months’ worth of cash to live on and resist the temptation to raid just to pay off your debt early. (See also: 7 Easy Ways to Start a $0 Reserve Fund)
Pros: You will sleep better
For many people, carrying debt from month to month is exhausting physically and mentally. It puts pressure on you. And this is completely understandable. Everyone has a different level of comfort with debt, and if you just can’t bear even the thought of a small debt burden, pay off those loans in full if you can. In many cases, early debt repayment provides psychological and financial freedom. (See also: How Getting More Sleep Helps Your Finances)
Cons: You can stop building credit
Believe it or not, paying off your debt early can hurt your credit. If you insist on always paying off your debts in full well before they fall due, your credit history may no longer be sufficient to earn a positive rating from credit agencies. As long as your debt burden isn’t too high, consistent, regular debt payments and paying your bills on time is the best way to build solid credit.
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