I’m thinking about paying off a 2.5% loan of $5,000 so I can be debt-free — and wonder if that’s a horrible idea. How to weigh the financial pros and cons of paying off small debt fast

What should you do?

While paying off a loan early sounds attractive, there may be some downsides. Understanding your loan terms and potential consequences of an early payoff is key to making the right decision.

When it makes sense to pay loans off early

One of the main reasons borrowers pay off loans early is to save money, particularly on high-interest loans.

You can use the money you save in interest payments to pad your emergency fund, save for a down payment, build a retirement nest egg or even increase your budget for entertainment and hobbies.

Paying off your loan early could boost your creditworthiness. Lenders look at a metric called the debt-to-income (DTI) ratio when assessing your eligibility for a loan.

The DTI is the percentage of your gross income that goes to debt payments. A low DTI suggests you can manage loan payments, meaning lenders will likelier approve you for a mortgage at a competitive rate.

Why you may want to hold off

However, just because you can pay off a loan early doesn’t mean you should. There are other ways you can use your money to improve your financial situation.

One potential issue is that some lenders charge a prepayment penalty when borrowers pay off loans early. Lenders do so to recoup any losses incurred from the interest they could have earned on your loan. That penalty could negate what you save in interest payments.

Ironically, paying off your loan early could negatively impact your credit score.