Should I settle my loan early (prepayment)?
That seems to be a question I’ve been seeing a lot and, coincidentally also, a lot of people responded with a resounding “Yes”. I’ve also seen some high profile personal finance people preach the practice of eradicating loans with a vengeance.
The way I see it… loans when used correctly can be very powerful, but when abused / ignorant it will be destructive.
Prepayment of a loan is the payment of the outstanding loan amount before it becomes due. For example, if you have a house loan for 35 years, you can opt to pay off the remaining balance at year 10 and free yourself from the monthly repayment from year 11 onwards.
Today, I want to take an objective angle on this – backed with numbers, of course.
Before we answer the question of the title, I want to bring up a term.
Opportunity Cost
This term often comes up in the subject of finance and economics. In truth, we experience this in our lives daily.
Opportunity cost refers to the loss of something when we choose an option over the other.
- When we snooze our alarm, we lose 10 minutes of time awake for the benefit of 10 more minutes of sleep/rest
- When we choose to drive to work, it takes 30 minutes of focus on the road vs paying RM10 for 30 minutes of free time in a cab
- Spending RM5,000 on a new phone takes RM5,000 away from other things like investment, a holiday to Thailand, a laptop for work, etc
- Investing in stock A means less/no cash to invest in other companies
We are always faced with the question of “what is the opportunity cost” when we make choices in our life. And we make lots of choices everyday, though some are more obvious than others.
Loans and prepayments present a very relevant opportunity cost issue – interest rates.
Interest Rates
Now, I am assuming you know what interest rates are and why it is relevant to loans aka borrowings – else you can read it up in Investopedia here.
I want to take a look at two things – the type and structure.
Type – Fixed Rates
Fixed interest rates are not affected by the changes of the market and will remain the same throughout the tenure of the loan.
Type – Variable/Floating Rates
Variable interest rates is tied to and will change in accordance to the market reference rate – this usually means the change of the OPR rates in Malaysia or “prime/base rates”.
Structure – Flat
Flat interest rate structure calculates the interest rates based on the original loan amount regardless of how much principal has been paid down.
Structure – Reducing Balance
Reducing balance calculates the interest rate payable based on the amount of principal outstanding. The interest portion of the loan instalment reduces (and principal portion increases) every month because the principal is being paid down in each instalment.
(Structure Trap) Rule of 78 (TRAP)
You can read up this full article from Loanstreet and get upset on how screwed up banks actually are.
This is commonly found in car and personal loans. In short, we pay most of our interest rates at the start of our loan as opposed to evenly distributing across the loan tenure. Yes, this means that if we prepay at a later stage of the loan tenure, there is not much interest savings because we would have paid up most of our interest portion by then.
Check out this graph by Loanstreet on how the interest amount looks like for the 2 structures + TRAP.
Use Loanstreet’s car/personal loan settlement calculator to see if it’s even worth prepaying.
And now…
We’re ready to tackle the 4 horsemen of loan for individuals.
4 Horsemen of Loans for Individuals
I’ll approach this section on 4 fronts – Interest rate type, loan structure, interest rate and prepayment opportunity cost.
Home Loan
Interest Rate Type: Commonly variable / floating
Loan Structure: Reducing balance
Interest Rate: Base Lending Rate minus 2.5% (Averages around 3.3% as of now)
Opportunity Cost: A home loan is typically quite a big sum. Hence, to prepay it involves coughing out a big capital. This will forgo a lot of other purchases / investment opportunities that may generate income more than the 3% – 5% interest rate (floating rate) paid here.
Verdict: Given the interest rate that we are paying and the reducing balance interest rate, it is better to use the capital to invest in assets that can generate returns beyond 5%, including ASB / ASM, REITS, etc. On top of that, if it is an investment property that is generating rental income, then is the monthly instalment actually still an issue?
Car Loan
Interest Rate Type: Fixed
Loan Structure: Flat + Rule of 78 Trap
Interest Rate: 2.9% – 3.3% (Effective Interest Rate is 5.5% – 6.2%)
Opportunity Cost: The amount of interest savings from prepayment depends on when we prepay. The earlier we prepay -> The more interest we save -> But the more capital we need. Prepaying early would require bigger capital, hence losing out on investment returns. Prepaying later would be sacrificing investment returns for not much savings in interest payment.
Verdict: Given the nature of the Rule of 78 and the EIR of about 6%, we are screwed all ways. It is highly likely not worth it to prepay since the interest savings would not be much a few years down the loan tenure. The capital can be better used to invest in assets that can generate higher returns than the interest rate and compound the returns from such investments. If we’re going to prepay very early in the loan, we might as well buy the car with cash.
Personal Loan
I have shared extensively on personal loan in my previous post here and why I wouldn’t take up any personal loans. I mean… look at the interest rates that we’d be paying!
Interest Rate Type: Fixed
Loan Structure: Flat + Rule of 78 Trap
Interest Rate: 4% – 7% (Effective Interest Rate is 7.5% – 13.5%)
Opportunity Cost: Forgo investment returns on the prepayment capital in exchange for saving effectively 7.5% – 13.5% interest charges annually. But again, this is subject to the Rule of 78 issue akin to the car loan.
Verdict: Given the high EIR, it is highly likely that prepayment is a better choice to avoid continue serving the loan. Suggest to use the loan settlement calculator by loanstreet to see how much you would save, then make your decision if the capital you have is better used to prepay or to invest and generate higher returns.
Credit Card Loan
Interest Rate Type: Fixed
Loan Structure: Special as it is based on your last month’s outstanding amount but with an interest that is compounded daily – read more on iMoney for the exact details
Interest Rate: 15% – 18% tiered and compounded daily effectively making it up to 20%
Opportunity Cost: Forgo investment returns on the prepayment capital in exchange for saving up to 20% interest charges annually.
Verdict: I’ve professed before that I love using credit cards compared to other payment methods. However, as a loan, it is ridiculous due to the way the interest is structured and also the exorbitant interest rates. If we do not pay down the credit card loan ASAP, we are incurring the interest rate wrath of up to 20% effectively (due to the daily compounding). I don’t know any investment returns out there that provides more than 20% returns consistently, so I’ll not hesitate to prepay this FULLY today. My opinion? Don’t even get into this loan in the first place.
Final Thoughts: The Ultimate Opportunity Cost
To answer the question that started this: It depends on what your opportunity cost is when you choose to prepay. In my choices above, I will not prepay if I can use the capital to generate higher returns elsewhere compared to the interest rate that I am paying for.
The ultimate opportunity cost here is this – getting a loan allows us to use less capital to acquire an asset in exchange for paying “interest rate”.
- If I have RM100,000…
- I can use RM10k to pay for the downpayment of a house worth RM100k.
- Borrow RM90k with an interest rate of 3%.
- Use my RM90k to invest into AXIS REIT which pays out 5% dividend yield.
- From my 5% dividend yield, I pay the loan of 3% and I still have 2% returns that I can reinvest to get more returns.
- Essentially, I own a house with RM10k, RM90k worth of AXIS REIT shares and generate a net 2% returns on the RM90k, which will be compounded.
- I have not rented out this property.
It’s a simple example, but it showcases the power of using loans the right way.
The other option being… I use RM100k to buy the house. I own a house and no cash or extra investment.
Are you seeing what I see?
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