That sounds like brilliant advice, and in some circumstances, it is. There are also times when you might not want to pay off a debt ahead of schedule. You’ll have to study your situation and consider the pros and cons of paying a debt off early.

The Advantages of Paying Off a Loan Early

There are some important advantages to paying off loans early, which is why so many people encourage it. Let’s look at some of them.

Freedom!

Think of Mel Gibson’s cry at the end of Braveheart. If you’ve been enslaved by debt for 3, 4, 5 or 30 years, paying your loans off ahead of schedule can bring an overwhelming sense of relief. There is a difference between going to work because you want to and going to work because you have to. When you pay off your loans early, that monkey on your back is gone, and so is the weight of the monthly obligation you have been carrying around. That’s a very good reason to attack your debt.

Reduced Amount of Interest Paid

When you take out a loan, you are agreeing to pay back the amount with interest. In most cases, the longer it takes to pay off the loan, the more interest you’ll pay. If you pay off a loan early, you will usually end up paying less interest than if you had paid the loan in the scheduled amount of time.

Use the early payoff calculator below to see just how much you would save on interest by paying off your loan early:

Go to the full page to view and use the calculator.

Free Up Your Budget

When you take out a loan, the lender has the right to claim a percentage of your monthly income until the loan is paid. That means you have to set aside that amount for the loan payment, month-in and month-out.

If you pay off your loan early, you no longer have to allocate that sum to debt payment. Instead, it becomes discretionary income. You can apply it to paying off another debt, add it to your savings or retirement funds, or use it to reinforce a part of your budget that’s been under stress. That gives you options you didn’t have before.

Lower Your Debt-to-Income Ratio

Your debt to income or DTI ratio is the percentage of your monthly earnings that you spend on debt payments. Your DTI ratio is one of the criteria that lenders use to determine your eligibility for credit. It’s especially important if you’re applying for a mortgage. Most mortgage lenders prefer a DTI ratio under 36%, and many will not lend at all if your DTI ratio is over 43%. A high DTI ratio can mean higher interest rates or even place loans out of reach.

Paying off debts early can reduce your DTI, which can be an important goal, especially if you’re considering applying for a mortgage.

You can use our Debt-to-income Ratio Calculator to determine your DTI.

Lower Insurance Costs

When you take out a car loan the lender retains an ownership interest in your vehicle until the loan is paid. Lenders want to protect that interest, so they typically require full insurance coverage. Once you pay your loan and own your car free and clear, you can decide how much coverage you need. If you choose to reduce your insurance, your cost will probably decrease. Remember not to cut your coverage too much. You could face serious costs in the event of an at-fault accident. Discuss your coverage with a qualified insurance agent and determine what you need.

The Disadvantages of Paying Off a Loan Early

There are significant advantages to paying off loans early, but some people might encounter disadvantages as well. These factors might be less obvious to most people. We all know that being in debt is bad, so getting out of debt early seems like it must be good. Before we leap to that assumption, let’s look at what can go wrong.

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Prepayment Penalties

Paying a loan off early usually means a lower total interest payment on the loan. That’s a good thing for you, but it’s not a good thing for your lender, who relies on that interest payments income. Some lenders impose prepayment penalties to ensure that they get the expected profit on their investment. Prepayment penalties are often used in car loans.

Before you decide to pay a loan off early, you should check the loan terms for a prepayment penalty. The penalty will usually be a percentage of the outstanding balance. The prepayment penalty may eliminate any advantage you’d get from reducing your total interest cost on the loan. Think carefully and calculate your costs and benefits before choosing to pay a prepayment penalty. You might be better off paying the loan on schedule.

Impact On Your Credit Score

You’d think that paying a loan off early would help your credit, but that’s not always the case. Credit scoring models consider a number of factors, including your credit mix, the length of your credit history, and the number of open accounts you have. They also give active accounts more weight than closed accounts.

Creditors like to see a mix of revolving credit (like credit cards) and installment credit (like a car loan or student loan). If you have only a few installment loans in your credit history, paying them off early could adversely affect your credit mix. Paying off an older loan (like a student loan) early could reduce the average age of your open accounts and your number of open accounts. It sounds strange, but an active account in good standing can often do more for your credit than a paid off account.

Paying off a loan early could dent your credit, but the impact is likely to be small, and it generally won’t last long. You’ll only need to be concerned if you have a thin credit file with a short history and few accounts. If you have an extensive credit history with multiple accounts, you probably won’t even notice the impact.

Even if the impact is small, it could make a difference, especially if you’re considering applying for credit, and a small drop in your score could raise your borrowing costs or even leave you ineligible.

Check Your Other Financial Goals

If you’re thinking about paying off loans early, consider the other things you could do with that money. The money you use to pay off your loan cannot be used for anything else, and that could mean missing an important opportunity.

Do you have an emergency fund? A good rule of thumb is three to six months in savings to cover an emergency. Do you at least have enough to cover a $1,000 emergency?

If your emergency fund is limited or you don’t have one, the money you’d use to pay off a loan early might be better used to start one or build one up.

If you have a 401(k) or IRA, an extra contribution to your retirement account could be a better use of funds than paying off a loan early. That’s especially true if your employer will match a portion of your 401(k) contribution!

The return on your investment could be greater than the interest you’d save by paying a loan off early.

This is an important consideration if you’re considering paying a relatively low interest loan, like a mortgage. Your investment earnings should exceed the interest rate you’re paying on the mortgage. That will usually make investment a better choice.

If you do decide to pay loans off early, be sure to focus on the right loans. You may be desperate to get that old student loan off your back but look at other debts first. If you’re paying 5% annual interest on a student loan and 20% on a credit card balance, prioritize that high-interest balance.

Keep emotion out of the picture and focus on your most expensive debts!

Should You Pay Off Your Loan Early?

There are many factors to consider when deciding whether to pay off your loans early. It might be a good idea, and it might not be. The choice will depend on your personal goals, your financial situation, and the terms of your loans.

Before making a decision, you’ll need to assess those factors and make sure paying a loan off early is the right choice. Freedom from debt may be just what your heart needs to soar, but you’ll want to make sure your wallet agrees with your heart!

The post Paying Off a Loan Early: Pros & Cons appeared first on FinMasters.

What is Credit Counseling?

Credit counseling, also known as consumer credit counseling, can help you organize your finances, develop a budget, plan for the future, and tackle your debt. A credit counselor is an objective third party that can give you a new perspective on your financial situation and ways that you can improve it.

Credit counseling can help you deal with your overall financial situation, or with specific problems like credit card debt, student loans or mortgage/housing debt.

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Who Provides Credit Counseling?

Most credit counseling agencies are non-profit organizations. Agencies are usually certified by a credit counseling association, like the National Foundation for Credit Counseling or the Financial Counseling Association of America. You can also find reputable credit counselors through the US Trustee Program. Your state’s attorney general office or consumer protection agency may also have information that can help you locate a qualified counselor.

Credit counselors are certified and trained in consumer credit, money and debt management, and budgeting.

How to Know if Credit Counseling is Right for You

Credit counseling isn’t necessary for everyone who has debt, but there are times when it makes sense to get a credit counselor’s help. The National Foundation for Credit Counseling suggests seeing a credit counselor if any of these criteria apply to you:

• You are using your credit cards to make purchases that you usually would pay for with cash;
• You are prioritizing your bills, meaning you are choosing to pay some bills and neglecting to pay others;
• You’re taking money from your savings or retirement accounts to satisfy some of your debt obligations;
• Your finances are causing stress or arguments at home.

You don’t have to wait until you are at the end of your rope to get help from a credit counselor. If you are struggling with debt or are unable to set up or follow a budget, a credit counselor can assist you. Getting help before your finances become an issue is often a better choice than waiting until you’re already in trouble.

What to Look For

There are plenty of reputable credit counselors, but not everyone who offers credit counseling services has your best interests in mind. If you have decided to use a counselor’s help, approach your choice as you would approach any major decision. Know what you are looking for, do research online to find out about the company’s practices and philosophy, and talk with friends who may have used the service. Remember to look for counselors who have been certified by either the National Foundation for Credit Counseling or the Financial Counseling Association of America.

Respected consumer credit counseling organizations will offer initial counseling and other services for free. Consider it a red flag if an agency pushes you to commit to their service or asks for upfront payment. Again, you will want to make sure that the credit counselor has been trained and is certified to provide you with the services you seek. Check with the Better Business Bureau and run online searches to get a sense of the agency’s reputation.

It’s important to feel comfortable with your counselor. A credit counselor should be able to listen to your concerns and provide options for you to consider. You should never feel pressured and coerced into any decision. A reputable credit counselor should provide you with free information about their services without requiring you to provide them with your details. The counselor shouldn’t request that information until you meet. If you’re not comfortable or if you feel like something’s not right, look for another counselor.

What to Expect When Meeting With a Counselor

If you decide to meet with a counselor, you’ll be more confident if you know what to expect. Depending on the agency, your meeting could be in person, on the phone, or in a virtual meeting. Expect that the initial visit will be 45 minutes to an hour. The counselor will gather information on your financial situation and ask questions to help determine your options and help you decide which of them is best for you.

Here are some questions that the credit counselor may ask:

• What is your household income?
• What are your monthly expenses?
• Do you have a budget?
• What debts do you have? For example, do you have a mortgage, student loans, or credit cards with balances?

Have this information ready:

• A list of your current expenses, including housing, food, utilities, loans, and credit cards.
• Recent pay stubs so you can provide information on your income.
• Credit card statements so you can provide the minimum payment information, due date, and interest rate.

The counselor may also review your credit report. After reviewing your information, the counselor will use it to help you develop a plan of action to meet your financial goals.

If your debt problems are manageable, your counselor may simply advise establishing a budget and savings plan to meet your goals. If you’re having serious trouble managing your debts, the counselor could recommend a debt management plan (DMP).

What is a Debt Management Plan

A debt management plan is a tool that can help you get back on track with your financial goals. A certified credit counseling agency will help you set up a plan. After working with a credit counselor, the counselor will offer an agreement to enroll in a DMP. You will make one payment each month to the credit counseling agency, which will then use the funds to make payments to your creditors. Because credit counseling agencies have relationships with creditors, they may be able to negotiate lower interest rates and reduced fees on your behalf.

Enrolling in a DMP may allow you to have more breathing room in your monthly finances by setting up a plan with just one payment. You also have a light at the end of the tunnel, so to speak, because most debt management plans have your debts paid off in 3-5 years, as long as you make the payments as scheduled. Most debt collectors will leave you alone if you are in a debt management plan and making your payments.

Keep in mind that while credit counseling is usually a free service, enrolling in a debt management plan comes with a fee.

Most agencies have an initial setup fee and then a monthly service fee. Some will waive the fee if the cost is too much for you, but that is not a guarantee. Also, be aware that the credit counseling agency may require you to commit that you will not apply for any new credit cards. This shouldn’t be an issue for you since you are trying to get out of debt, but you need to know that this may be a requirement.

Is a DMP Right for You?

A debt management plan may or may not be a good idea for your situation. A DMP works well if you have a lot of unsecured debt, like credit card debt. A DMP usually does not work with secured debt like a home or car loan. You also cannot use a DMP for student loan debt.

It is also possible to do the legwork that a credit counseling agency does on your behalf on your own. You may not be able to negotiate the waived fees or lower interest rates the agency can, but if the cost of setting up the DMP is more than you can handle and you have the time to negotiate with your creditors, it might be worth not using a credit counselor.

How Does a DMP Affect Your Credit

Some debt relief plans can affect your credit. You may be required to close credit card accounts, which can raise your credit utilization ratio and lower the average age of your accounts. That can have an impact on your credit, especially in the short term. A DMP usually will not have a long-term negative impact on your credit. You’ll be making regular on-time payments to your creditors through the credit counseling agency, which is good for your credit.

If you miss a payment, your credit counselor could cancel your debt management plan. Your creditors could then report missed or late payments or send your account to a collection agency. That could have a significant impact on your credit.

The Choice is Yours

Whether your counselor suggests simple changes to your budget and spending habits or a debt management plan, the final choice is yours. Consider the counselor’s recommendations and take some time to think about your options. Don’t feel pressured to sign an agreement at this first meeting. If you think you are being pushed to sign any agreement, walk away and find another agency. A debt management plan may be a good idea, but you should not enter it lightly. Take some time to think about it.

If you don’t fully understand the plan the agency is offering, ask for more information before making a decision.

Bottom Line

If you feel like your debts are out of control, credit counseling can have real benefits. A certified credit counselor can provide you with tools to learn to budget and plan for the future. If you need more help, a debt management plan may be just what you need to get back on track and out of debt in 3-5 years. Just do your homework and find a reputable agency to help you.

Beware of anyone who tells you they can fix your debt problems or repair your credit overnight for a fee. Companies that tout that kind of help are not being honest with you and could be outright scams. A legitimate credit counseling company won’t pressure you, make extravagant promises, or require a fee upfront. They will work with you to find a solution that fits your needs and circumstances.

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