Paying off a loan ahead of schedule sounds like a financially smart move.
No more monthly payments, less interest to deal with, and one less item on your budget. But that decision isn’t always as clear-cut as it looks. There are trade-offs—some obvious, some not—and in a few cases, paying off early can even cost you more than finishing the loan on schedule.
This article breaks down prepayment penalties, real interest savings, and the opportunity cost of using your money elsewhere. If you’re aiming to make a clean break from your loan, you’ll want to know what you’re walking into. And for those reviewing financial options, Innovation Federal Credit Union offers personal banking tools and loan products that may help you make more informed, flexible choices.
Not Every Lender Wants You to Pay Early
Some loans are structured to discourage early repayment. The reason is simple: lenders make their money from interest. When you shorten the loan, they collect less of it. So to protect their revenue, they often include prepayment penalties in the loan agreement.
How Prepayment Penalties Work
There are three common types:
- Flat fee: A fixed charge, regardless of how much is left on the loan.
- Percentage-based: A penalty based on a percentage of your remaining loan balance—often 1–5%.
- Sliding scale: A higher penalty if you pay early in the term, which decreases as you get closer to the end of the loan.
Let’s say you owe $15,000 on a loan with a 3% penalty. Paying it off early means an extra $450 right out of pocket. If your interest savings don’t exceed that amount, the move makes no sense financially.
Canadian lenders vary on whether they impose these penalties. Many personal loans are open, meaning they allow early repayment without fees. Others, especially secured loans or those from subprime lenders, may be closed and carry harsh penalties.
Always check the fine print. If you’re unsure, ask the lender directly for a breakdown of the total cost to repay early.
Will You Actually Save Much in Interest?
Most installment loans use an amortization schedule. In this setup, you pay more interest at the beginning of the loan and gradually shift toward paying more principal over time.
If you’re two or three years into a five-year loan, most of the interest has already been paid. Early repayment at that point won’t save you nearly as much as it would have in the first year.
Fairstone, a Canadian non-bank lender, notes this in their guide on early repayment: the closer you are to the end of your term, the lower your savings. Even if you do eliminate future payments, the interest you’ve already paid is gone for good.
Could That Money Be Working Harder Elsewhere?
Paying off debt is good, but using cash strategically is better. You need to weigh what you’re giving up when you choose to put your money into a loan.
Three Alternative Uses to Compare
- Higher-interest debt: If you have a credit card with a 20% interest rate and a loan at 8%, it’s not hard math. Focus on the high-interest debt first. Every dollar thrown at the loan is a dollar not used to kill more expensive debt.
- Investing: Let’s say your loan has a 6% interest rate, but your investment account reliably earns 8%. You’re sacrificing growth for emotional satisfaction. Unless you have an overwhelming urge to be debt-free, investing might leave you ahead in the long run.
- Emergency savings: Many borrowers drain their savings to wipe out a loan. Then they get hit with an unexpected medical bill or job loss. Without a safety net, they turn to credit cards or payday loans — exactly the kind of debt they were trying to avoid.
Credit Score Impact
Paying off a loan early does affect your credit, but not in the way most people think. The biggest benefit is lower overall debt. That improves your debt-to-income ratio, which lenders care about. However, there can be slight short-term drawbacks:
- Shortened credit history: Installment loans contribute to your credit age. Closing one early might reduce the average age of your accounts.
- Reduced account mix: A diverse credit mix helps your score. If you only have revolving credit (like credit cards) after closing a loan, that could knock your score down a few points.
These are minor and usually temporary. If your goal is to qualify for a mortgage or other large loan soon, pay close attention. Otherwise, credit score effects should not be a major factor in the decision.
Final Word
Don’t assume early loan repayment is automatically the best move. It depends on the loan’s terms, your financial position, and what you’re giving up by making that payment.
Check the numbers. Ask for a full payoff quote. Compare it to what your money could do elsewhere. If everything lines up then go ahead and pay it off. If not, hold onto your cash and let the loan run its course.
