Should I Pay Off a Personal Loan Early or Pad My Savings?

Not sure whether to divert more money to savings or chip away at a loan? Here's how to decide.

There are plenty of reasons to borrow money via a personal loan, and the good news is that if you make monthly loan payments on time, borrowing shouldn't hurt your credit score -- whereas racking up a large credit card balance could damage your score. If you have personal loan debt but your circumstances mean you can make more than your minimum monthly payments (say, your income went up), you may be eager to pump extra money into that loan to get rid of it sooner and save yourself some money on interest.

But is paying off a personal loan ahead of schedule a smart idea? Or are you better off using spare cash to add to your savings account balance?

What do your emergency savings look like?

Your primary financial goal, no matter your financial situation, should be to have an emergency fund with enough money to cover three to six months of living expenses. That way, if you lose your job or encounter some unplanned bills, you can cover your costs without resorting to debt or falling behind on your financial obligations and damaging your credit score.

Now, say you're sitting on extra money every month that could go into your savings or go to chipping away at a personal loan balance. To decide where that cash should go, you just need to ask one simple question: What does my emergency fund look like?

If you have enough in savings to cover at least three months' worth of bills, then you may want to use your extra cash to pay off your personal loan. But if you're short on emergency savings, that should take priority.

The good thing about personal loans is that they generally have fixed interest rates. You shouldn't feel pressured to pay off your loan early for fear that your interest rate will go up in time. In fact, if you stick to your loan schedule, you may find that it helps you build credit -- those timely payments are recorded and added to your payment history, the single most important factor in calculating your credit score.

Is there any downside to paying off a personal loan early?

Though it's possible for a personal loan to include a prepayment penalty clause, most of these loans don't ding you for paying off your balance ahead of schedule. If you're all set on emergency savings, there's no reason not to use your spare cash to knock out that loan faster. Though personal loans aren't the worst type of debt to have, they're also not the best, so the sooner you're able to get rid of yours, the sooner you can enjoy the freedom of not having a loan balance hanging over your head.