It is difficult to find a person who doesn’t have any form of debt, whether it is a car loan, credit card, personal loan or mortgage the probability is that almost every one of us have it. It could be said, though, that nobody likes having a loan, but the cruel reality is that at some point in our lives we will have to have it. Unless we are prepared to pause our purchases until we save enough to buy a car, a house, or other items we would like (until we are old enough to retire, because then we will have enough money accumulated). So we do have a loan, the next is is to go through the process of paying off a loan before its maturity. Should you pay off your loans?
Although nobody likes having debt, we should also considered the reason why we have debt. If the reason is that we have taken a loan to purchase (invest) in a necessary goods such as: car, renovation, or purchase a house, than it is good to have a loan. Maxing out your credit card limit to purchase unnecessary things, or to party all night long, is one of the worst ways to manage your finances. Why? Because, aside of the short-term satisfaction that you have when buying a piece of jewelry, or cloths, what remains in the long run is your debt. Short term pleasure has been transformed into long-term obligation ascertain with decreased liquidity and increased costs.
What to consider before paying off a loan?
Regardless of the reason you have had for taken a loan, the fact remains that you have a loan, and you should repay that loan. So, the question then becomes – Should you be paying off a loan earlier? There is no simple answer to this question. The complexity in answering the question is imposing the need to carefully analyze couple of issues:
- The existence of penalty for early repayment;
- The interest rate charge – or saving for that matter;
- The time period of additional funds available;
- Alternative use of available funds – should you invest them;
- The effect of early repayment on your credit score;
- Repayment strategy;
Before proceeding in-depth about the aforementioned issues, one thing should be considered. Before even thinking about paying off a loan, you should have an emergency fund. This fund should help you to bridge over any unforeseen expenses, or even survive the unemployment period, in case you find yourself unemployed. There is no clearly define rule regarding the size of the fund, but very often it is said that it should be enough to cover six month expenses. In some cases it is said that the fund should be equal to six months of income. The later making more sense, because that way you could retain your life style (at least for six month without any income). Off course, the size of the emergency fund at the end is your decision.
Coming back to the issues that should be considered before paying of a loan. You should consider the expenses as well as any additional income you could generate (saving the interest payment) when repaying your loan. Meaning that primarily you should see if there are any penalties or charges for early repayment. Some institutions charge an early repayment fee. The amount of the fee varies from institution to institution but you should definitely take it into account. Secondly, you should estimate the money you will save if you pay off your loan earlier. This is in terms of interest rate you would otherwise pay if decide not go for early repayment. This is closely related with the alternative use of available funds. Meaning that you should analyze if you could invest those money in interest earning instrument or an instrument that will provide you with a return. In addition, you should analyze the money you could be earning if you decide to invest your money in a CD, the stock market or any other high yield instrument.
Before paying of a loan, you should take into account the durability of the available funds you have on hand. In other words, do you have additional funds for a short period of time, or the increased availability of funds will proceed in the future. This is important because if you make a commitment for early repayment or faster repayment of your loan, you should be sure that you will have available funds in the future. In case you have extra money this month because of some bonus or some extra activity you got paid for, then by no means should you consider early repayment.
Considering the effect, from paying off a loan, on your credit score. Noteworthy is to mention that it will have positive impact. Meaning that if you pay off your debt before maturity it will show a stability in your behavior for managing your finances i.e. financial obligations.
Another thing to consider before paying off a loan is the repayment strategy. There are a couple of basic strategies that you could apply, such as increasing the monthly payment strategy, or a lump sum payment strategy, etc. Read the get out of debt strategies post.
Summarizing the benefits and drawbacks of paying off a loan faster
The benefits arising from paying of your debt faster are:
- Saving the amount of interest rate you would pay during the remaining life of your debt;
- Improving your credit score for any future needs for loan;
- Increase the availability of funds in the future because you do not have any monthly installment;
- Free up funds so you could accumulate capital for future purchases, in case you can save the amount you would otherwise pay as installment.
The drawbacks arising from paying of your debt faster are:
- Possibility to end up paying an early repayment penalties;
- Tying up available capital;
- Wrong analysis about your future income and capital needs could result in applying for new loan in short period of time, thus end up paying the interest rate “twice’. This is in a sense that in many cases at the beginning of the repayment period big portion of the monthly payments is assigned to the interest payment and certain portion goes toward principal payment. Thus, paying loan before maturity date means that you have paid big portion of the interest. In case you need to take on a new loan, you will again start from beginning and thus have to pay higher amount of interest.
- You don’t get to use the extra money you have in hand.
It could be stated that the decision for paying of a loan early should not be taken for granted. This decision could have strong (positive or negative) on your financial future. Thus, before making the decision to pay off debt earlier always take into consideration all the relevant aspects and issues. Also, always consider the advantages and disadvantages that will come with the payment of loans before its maturity. Along with your ability to pay off your debt earlier and the effect on your life style should always be taken into account.