The idea of being debt-free early in life is tempting because nobody wants to be tangled in debt in the long run, especially for high-interest debt.
Maybe you have a stash of extra cash that you can use or you just got a nice bump to your salary—should you pay off your loans early, as appealing as it sounds?
Before you decide to pay off your loans ahead of schedule, do a lot of research and list the pros and cons to ensure that it’s a decision that you won't regret. After all, there are definite benefits, but there are also several potential drawbacks too.
Disclosure: we won’t dive into a specific type of loan because all loans are forms of debt.
The pros - the benefits of paying off your loan early
If you had a mortgage, an auto loan, a student loan and a personal loan, which would you prioritise paying down first?
1. Save on interest
Everyone knows that the longer your loan, the longer the interest you will pay over time. Always remember that when you make a monthly payment on a loan, you are paying the amount you borrowed and the interest and fees for the loan.
For example, let’s say you take out an RM50,000 loan with a 10-year repayment term and a 2.5% interest rate, you will end up paying a total instalment of RM62,500. Compare that to paying the same loan plan (2.5% interest) but for five years: RM 56,250. You can save RM6,250 if you pay off your loan five years earlier. We did this calculation based on this calculator by CIMB.
This could be the main, and possibly, the biggest benefit of paying off your loan early is that you can save up on money in the long-term because you no longer pay the interest over time.
However, in some cases, your loan interest could be precomputed, which means your interest is calculated upfront at the beginning of the loan and, so the amount of interest you pay is considered fixed. In this regard, it may not matter if you are paying off your loan early because you are still responsible for the full interest on the loan.
2. Improves your credit profile
Not all debt is bad for you—a mortgage, for example, gives you the opportunity to own an asset which is crucial in building your wealth.
One crucial way to improve your credit score is to get out of debt—fast. One of the reasons borrowers have poor scores is because they default on their debts.
So paying off your loan faster could help you maintain a healthy credit score which then affects your credit report. Need more tips on how to manage your money and get out of debt? It doesn’t harm to check our money tips section. If you need professional help, you can get free financial help and advice from AKPK.
Paying off your loan early also eliminates any risk of missing payments late or missed payments, which again, affects your credit profile.
Lenders and banks will refer to your debt service ratio before approving a loan. Having a paid-off loan may lower your debt-to-income ratio, a crucial metric used by the authority to make credit decisions. You could potentially qualify for better terms if you, for example, paid off your auto loan before you apply for a mortgage loan.
2. Gain peace of mind by being debt-free
As much as people need to carry some debt to experience social mobility and have a developed credit score, holding onto debt can be physically and mentally exhausting. Many people live paycheck after paycheck just to clear off their debt.
Everyone manages debt differently, some can handle it better while others struggle. If having a pool of debt makes you feel anxious, it won’t be a bad idea to pay those loans off in full if you can. Paying off debt early can help you achieve both financial and mental freedom.
And unfortunately, not being able to pay off your debt as agreed comes with severe consequences. Creditors have certain legal rights that they can exercise on you if you don’t pay your debt accordingly. If you default on a loan backed by collateral, you could risk losing that property or your car.
3. Free up funds for other expenses
Getting your monthly paycheck is nice until you use it to pay off expenses and all your debt. Now imagine not needing to put aside RM500 monthly on your car, for instance. Feels good, isn’t it?
Paying off your loan early gives you access to extra money each month, and you could use some or all of that cash to pay down other debt, build up an emergency fund if you haven’t already, build up your savings or invest.
Though paying off your loans early can strengthen your financial foundation, there are some downsides to it too.
Cons - the drawbacks of paying off your loan early
Where did all the money go? If you use up all your savings to pay off your loan, you may not have additional money when you really need it.
1. Less money in your pocket
Putting all your eggs in one basket (or in this case, loan)—may backfire if there’s an emergency that requires a large amount of money.
Paying off your loan early means you are pumping a large sum of money such as RM10,000 into a mortgage or auto loan, but the real question then is, where is that money coming from?
Make sure the money that you are using is not coming out of your emergency fund because that cash should only be used for emergencies. Play your cards right and make sure you keep at least three months worth of income on hand in cash to help cover any potential emergencies.
On top of that, it doesn't make sense to pay off your loan early if you have already paid off most of the loan interest because, by the time you reach the end of your lending period, your interest payments are much lower. You could be paying as little over RM200 in interest per month by the time you reach your third year—and this decline will only continue. At this stage of the game, you are borrowing money interest-free so it’s better to hold onto your cash.
2. Build additional funds for other goals
When you pay off your debt early, you are actually paying an opportunity cost. In other words, you are losing something as a result of gaining something else.
Being debt-free is a great relief but it also means you lose out on the opportunity of using the additional funds for other financial needs or endeavours such as putting them up in your retirement fund, paying a down payment on a house, making investments or funding college for your kids. As much as we all want to be debt-free, you shouldn't do it at the expense of larger goals, especially those that affect others in your life such as your kids.
For example, you are giving up on gains from investing in the stock market or through other platforms such as robo-advisors or unit trusts. If you have already started saving up for a down payment, you may need to start saving again and building additional funds to achieve other goals in life.
Related: Personal Financing: Good or Bad?
Some loans have prepayment penalties within their terms and conditions. Always go through the T&C before signing up for a loan!
3. Prepayment penalties
Some loans may impose penalties and fees on borrowers who attempt to pay down their loans before the given loan tenure. How can you avoid this penalty? Just ask your bank or lender to see if they have such policies on early or extra repayment.
We recommend that you always read loan terms carefully and check for language that explicitly states the loan doesn't carry prepayment penalties.
4. Not enough funds for other debt
Before you park a large chunk of your savings into your mortgage, for example, you should also consider other loans or debt you may have like credit cards, auto loans, student loans, and personal loans.
If you are looking to pay off your mortgage, check the higher annual percentage rate (APR) of your other loans and do a quick comparison.
P.S.: the APR of a loan is the total amount of interest you pay each year (before compounding of interest), and is represented as a percentage of the loan balance.
If your other debts have higher APRs than your mortgage, it may be better to pay down those balances first to save money in interest.
All things considered - don’t overthink it
Having a secure monthly budget and safety net is a must. Always weigh the pros and cons before making any decision.
If you are looking to apply for a personal loan, it won’t harm to check out the personal loans offered on our website.