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Is it actually best practice to overpay on a loan?

Is it actually best practice to overpay on a loan?

Should you overpay on the likes of short term loans?

Overpaying your short term loan might seem like a smart thing to do, especially if you have the money available. Why wouldn’t you make extra payments to bring down your monthly payments or the overall cost? After all, it may be a great help in reducing your overall interest payments on a monthly basis.

In some cases, this is absolutely correct. Making an overpayment can, in some cases, end up saving you money. This is especially true for things like credit or store cards and mortgages, or many longer term personal loans. However, repaying some loans early may actually result in additional costs.

Some lenders will charge an early payment charge if you clear your loan early, which might end up costing you more than if you were to pay by the agreed date. This is used most commonly on 0% loan or finance agreements, in which a lender might not be making money from you otherwise. They anticipate that the recipient of the finance agreement will want to clear the full amount before it starts to incur interest charges, so will charge you an early repayment fee to ensure that they recover some of their costs.

It can be a complex market, so it’s recommended to completely understand the ins and outs of any loan you take out. Make sure that you are aware of any fees or costs involved, as it can end up saving you a lot of money.

Let’s take a look at some different loan types to compare the pros and cons of making early payments:

Payday Loans

Payday Loans, by nature, are short term advances designed to be completely cleared before your next payday. Most of these have much higher interest rates than other forms of credit, so in many of these situations it is wise to clear a payday loan as soon as possible.

Depending on your agreement, you might be incurring daily interest charges or a set amount of interest. You should find out from the lender whether there are any costs or charges involved if you were to pay before the due date, and if not, make the payment as soon as it is realistically possible.

A Bad Credit Loan

Bad credit loans are another example of a higher interest loan. These are usually short term loans, though they may have a longer term than a payday loan, so it is possible to incur higher interest charges.

As with a payday loan, it’s recommended that you contact the loan provider to find out if there is a cost to make overpayments, and if not, overpay as much as is reasonably possible whenever you have the additional funds.

Personal Loans

Personal loans are generally a longer term solution to personal borrowing, so they will usually have a much lower APR. This gives the bank or lender more of an incentive to add early repayment costs – obviously, this will vary from lender to lender, so you should read the terms and conditions in full before you make any extra payment.

A lot of personal loans will allow you to overpay, but clearing the loan in full before the agreed date might incur additional fees. It might be worth working out whether these fees will cost less than a full term’s worth of interest – otherwise, you can make extra payments to reduce the balance without clearing the full amount.

Credit Cards

Credit cards work differently to other types of borrowing, in which you have a minimum monthly repayment and a maximum account balance. The minimum payment will change based on the outstanding balance, which you can reduce or add to at any time.

It’s recommended to pay off as much as possible on your credit card on a monthly basis: you won’t receive any additional charges for clearing your credit card balance early, as it is an open account. There is no ‘final’ due date, as you can use the card for as long as you need.

Tips and tricks

Some of these situations are quite difficult to work out whether you should make overpayments or not. If there are early repayment fees involved, you should try to work out which will end up costing you more: a longer period of incurring interest charges, or the one-off early repayment fee. It will be different in each circumstance, based on what the fees are and how long you have left on the loan.

If you do have extra funds available to put towards a loan, but you don’t want to incur any additional fees, you may want to put the money aside each month. It might make a healthy buffer, so if your financial situation were to change, you still have the savings to clear any due payments.