Being debt free is something everyone dreams about. After all, no one wants to be tangled in debt over a long period of their lives, especially with interest accumulating as time goes by. Well, if you recently got yourself a nice bump in your salary, or if you have some extra cash lying around, why not try paying off your loans early?
Before you go ahead and do so, take some time to research the pros and cons of paying your debts early. While paying off your loans early certainly has its advantages, it does come with some drawbacks as well.
The pros of paying off debt early
Save money on paying interest
One of the biggest advantages of getting rid of debt early is that you will have to pay less interest in the long run. Every loan you take needs to be paid in full eventually plus interest. The longer the tenure of the loan means that you will need to pay more interest over time.
For example, let’s say that you took out a RM10,000 loan with a 3-year tenure and a 8% annual interest rate. By the end of your tenure, you would have paid around RM11,281, with your total interest paid being around RM1,281. However, if you paid off your loan within two years instead, you would only be paying a total of approximately RM10,855. This saves you about RM426 in interest.
The biggest benefit of paying off your loan early is that you can save up on money in the long-term. This is because you are no longer paying the interest over time. However, depending on the terms of your loan, the interest could be precomputed. This means that your interest is calculated upfront at the beginning of the loan. So, the amount of interest you are paying is fixed. Under such circumstances, it does not matter how early you pay off the loan as you are still responsible for the full interest amount.
Looks good on your credit report
The most effective way to improve your credit score is to get out of debt fast. 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 (DSR) and your credit score before approving a loan. Financial institutions use this DSR to make credit decisions. If you are diligent in paying off your loans on time, your DSR will remain low. A good credit score combined with a low DSR will signal to a lender that you are a very reliable borrower who will likely not default on their payments.
Free up funds
Everyone looks forward to their monthly salary. However, it doesn’t feel as good if a huge chunk of it has to go towards paying off your debt. Pay off your loan early and you will have extra cash on hand each month.
The extra cash you save can be used for other productive things, such as paying down other debt, building up an emergency fund if you haven’t already, building up your savings or investing.
Live stress-free
A simple but often overlooked benefit of paying off your debts early is the peace of mind you can enjoy. This is from not having to worry constantly about owing lenders money.
Stress can be a major hindrance to your financial journey as it can lead you to make bad decisions. By getting rid of your debt early, that is one more thing off your plate so that you can focus your attention elsewhere.
The drawbacks of paying your loan early
Though paying off your loans early can strengthen your financial foundation, there are some downsides to it too, as unbelievable as that might seem.
Less money on hand
The first and most obvious drawback is that you have less money in your pocket. This might not be so bad if your income can support the amount of debt you owe each month. However, for those who are on a tight budget, not having enough cash on-hand may lead to more problems than it is worth.
You know things are getting bad if the money you use to pay off your loans early is coming from your savings or emergency funds. You need to play your cards right and make sure you keep at least three months worth of income on hand in cash. This is to help cover any potential emergencies. Even better, if you can save up to six months worth of emergency cash.
Another thing to consider is that it doesn’t make much sense to pay off your loan early if you have already paid for most of your loan interest. This is because by the time you reach the end of your lending period, your interest payments are much lower.
Miss out on other goals
Everything has an opportunity cost, even paying off loans early. Getting rid of your debt sooner rather than later is good. Just remember that this does mean you can’t use that money to build towards your other goals. In exchange for the relief you gain, you lose out on the opportunity of using the additional funds for other financial goals. You could be using that money towards your retirement fund, investing, or building up your kids’ college fund.
Being debt-free is great, but it should not get in the way of your larger-scope goals, especially those that affect others in your life such as your kids.
Prepayment penalties
Some loans may end up penalising you for attempting to pay down your loan before your tenure is up. You can avoid this by simply asking your bank or lender to see if they have such policies on early or extra repayment.
All things considered, it would be best not to overthink things too much. What is most important is to have a secure monthly budget and a robust safety net. Before taking any loans or other kinds of debt, always weigh the pros and cons beforehand. If you are looking to apply for a personal loan, you can utilise iMoney’s Smart Search Tool to find the right one for your current needs.
