Early loan settlement saving:
formula and worked example

What settling a loan early actually saves

Paying off a loan before its scheduled end removes the interest that would have accrued over the remaining months. That interest is the saving. Against it stands the prepayment or foreclosure charge some lenders levy, and the opportunity cost of the cash you use.

The headline question is simple: is the interest you avoid larger than the fee you pay? The answer depends on how much of the term is left, because on most amortising loans interest is front-loaded and shrinks as the balance falls.

The formula: remaining interest minus the fee

Take the interest still scheduled to be paid from today to the end of the loan and subtract whatever the lender charges to close early.

• Scheduled interest: the interest remaining on the repayment schedule from the settlement date, not the interest for the whole loan.
• Prepayment fee: the charge the lender applies for early closure, flat or as a percentage of the outstanding principal.

Ask the lender for a foreclosure statement. It shows the outstanding principal, the interest accrued to date and the fee, so you do not need to estimate.

Interest on an amortising loan is front-loaded, so the amount remaining depends heavily on how far into the term you are. Halfway through a long loan, much more than half of the principal may still be outstanding, but far less than half of the original interest bill remains. That is why the first few years offer the biggest saving for early settlement and the last few offer almost none.

Worked example: 46,000 of interest against a 5,500 fee

1. 1Identify remaining scheduled interest: 46,000.
2. 2Identify the prepayment fee: 5,500.
3. 3Subtract: 46,000 - 5,500 = 40,500.
4. 4Express the fee as a share of the interest: 5,500 / 46,000 is about 12%, so roughly 88% of the interest is kept.

A saving of 40,500 is a real gain, but it is gross. If the cash you use would otherwise have earned a return or served as an emergency reserve, subtract that too.

Reading the result against the cash you use

Compare the saving with the principal you must put in. Clearing a balance of 300,000 to save 40,500 is a very different proposition from clearing 100,000 to save the same amount. The ratio of saving to cash used tells you the effective return of prepaying.

Another useful comparison is with the interest rate on the loan. Prepaying a loan is similar to earning that rate on the money you hand over, risk-free. If you could earn more elsewhere with acceptable risk, or if the cash would leave you short, keeping the loan may be the rational choice.

• A negative result means the fee outweighs the remaining interest.
• Settling in the last months of a loan usually saves little because little interest remains.
• Part-prepayment can capture much of the saving while keeping some liquidity.

It helps to calculate the saving as a share of the outstanding principal, since that is the cash you commit. If you settle a balance of 250,000 and save 40,500, the yield on the cash is about 16% of principal over the remaining term. Divide by the years left to compare it with other uses of the money, remembering that the saving is certain whereas investment returns are not.

Some borrowers also weigh the psychological value of being debt-free. That is legitimate, but it should be a conscious choice, not a reason to ignore a poor net saving or the loss of a safety cushion.

How the saving responds when remaining interest changes

A 10% higher remaining interest raises the saving by 4,600, which is about 11% on the original 40,500, a slightly larger proportional move than the interest itself. That is because the fee is constant and does not scale. The earlier in the term you settle, the more interest remains and the smaller the fee looks in comparison.

Mistakes that make early settlement look better than it is

• Using the total interest for the loan instead of the interest remaining from today.
• Forgetting extra charges such as part-payment penalties, documentation or taxes on the fee.
• Ignoring that clearing the loan removes a tax benefit you may have claimed on interest, where local rules allow one.
• Draining savings to settle and then borrowing again at a higher rate when an expense arises.

Watch out for the timing of the final instalment as well. Settling a few days before an instalment is due can avoid paying that month's interest in full, but check how the lender computes accrued interest to the settlement date.

A short checklist before you settle

Write down the remaining interest, the fee, the cash required and what that cash would otherwise do. If the net saving is meaningful and the cash is genuinely surplus, settling makes sense.

1. 1Obtain a written foreclosure statement.
2. 2Subtract the fee from the remaining interest.
3. 3Compare the saving with the cash you put in and with your alternatives.
4. 4Keep an emergency reserve before committing the rest.