Pros and cons of paying off loans in full versus monthly
Does it make good financial sense to pay a loan in full or make the regular monthly payments?
Making monthly loan payments on cars, homes, student loans and credit cards can become a drain on your paycheck, leaving you with less cash to do the things you want to do. Paying debt off early can save money in the long run but can reduce the amount you have to spend for necessities. Your desire to be debt-free or make regular monthly payments, in addition to having an emergency savings and funds for other endeavors, depends on your financial goals.
Becoming debt-free is a worthy goal. Setting specific financial goals and establishing a spending plan will help put a strategy in place to achieve that objective. During the goal setting process, there are several key items to consider:
- Are there any penalties for early pay off? A pre-payment penalty is sometimes assessed on mortgages or other installment loans. Be sure to read the original loan documents to determine if this is part of the loan.
- Is there enough income to meet basic needs while targeting the debt? If you establish a plan that doesn’t leave enough for food, transportation and utilities, the plan cannot succeed.
What are you willing to give up during this course of action?
- Fewer dollars going toward savings or an emergency fund? This is a poor idea as lack of savings or emergency money can sidetrack a “debt-free” plan quickly when an unexpected expense comes up.
- Less money spent on entertainment and eating out? Be honest about how much you are willing to sacrifice. And remember that cutting back in these categories is only until the debt is paid off. It doesn’t have to mean never going out; it means cutting back and actively planning how much of your budget to use while still working to achieve the end goal of paying off debt.
What effect will achieving this goal have on your credit score?
- The effect will be positive if you have an established credit record and you pay off debt. Since payment history and credit utilization are important factors in determining a credit score, a positive payment history and no outstanding balances will optimize your credit score.
- If the credit history is not very long or there is a thin file, paying everything off early could have an adverse impact on the credit score. It takes a minimum of 12 months to establish and 12 to 24 months to reestablish a positive credit history.
The pros of paying off debt early is increased cash flow, less interest paid on loans and a higher credit score. The cons are that while working to achieve the ambition of being debt free, there will be fewer funds available for extracurricular activities, like dining out, and travel in the short run. A short term sacrifice is worth it for greater financial security.
Michigan State University Extension offers financial literacy and homeownership workshops throughout the year to help you become financially healthy. For more information of classes in your area, go to either http://msue.anr.msu.edu/events or www.mimoneyhealth.org. Additionally, you can take the Financial Health Survey at MI Money Health to assess if you’re financially healthy and discover more ways you can improve your financial health.
Michigan State University Extension has released a new toolkit for homeowners who are experiencing or have previously experienced foreclosure. This toolkit will equip these individuals and families with tools to help them recover their financial stability, in the case that a recovery of their home is not possible. The toolkit is available to download free at MIMoneyHealth.org.