Pre-payment of a loan is the payment of the outstanding loan amount before it becomes due. This usually comes in the form of a car loan.
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.
The way I see it, loans when used correctly can be very powerful, but when abused / ignorant it will be destructive.
Today, I want to take an objective angle on this – backed with numbers, of course. Before answering the question “Should I settle my loan early?”, I want to highlight a term.
Opportunity Cost
This often comes up in the subject of finance and economics. In truth, you experience this in our lives daily. Opportunity cost refers to the loss of something when you choose one option over the other.
If you snooze your alarm, you lose 10 minutes of being awake for the benefit of 10 more minutes of sleep/rest.
When you 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.
You will always face the question of “what is the opportunity cost” when you make choices. And you make lots of choices every day, though some are more obvious than others.
Loans and prepayments present a very relevant opportunity cost issue – interest rates.
Interest Rates
Fixed Rates
Fixed interest rates are not affected by the changes in the market and will remain the same throughout the tenure of the loan.
Variable/Floating Rates
Variable interest rates are tied to and will change in accordance with the market reference rate – this usually means the change of the overnight policy rates (OPR) in Malaysia or “prime/base rates”.
Structure – Flat
A 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 the principal portion increases) every month because the principal is being paid down in each instalment.
Structure (TRAP) – Rule of 78
This is commonly found in cars and personal loans. In short, you pay most of your interest rates at the start of the loan as opposed to evenly distributing across the loan tenure.
Yes, this means that if you prepay at a later stage of the loan tenure, there are not much interest savings because you would have paid up most of our interest portion by then.
You can read up about the rule of 78 by doing your own research, but be warned that you might get upset once you discover how some bank loans work!
4 Horsemen of Loans for Individuals
I’ll approach this section on four fronts – interest rate type, loan structure, interest rate and prepayment opportunity cost.
1. House 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 house loan is typically quite a big sum.
Hence, to prepay it involves coughing out big money! 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’s an investment property that is generating rental income, then is the monthly instalment actually still an issue?
2. 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 many savings in interest payment.
Verdict: Given the nature of the Rule of 78 and the EIR of about 6%, we have screwed all ways.
It’s 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 you want to prepay very early in the loan, you might as well buy the car in cash!
3. Personal Loan
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 issues, similar to the car loan.
Verdict: Given the high EIR, it’s highly likely that prepayment is a better choice to avoid serving an extended loan.
I suggest using a loan settlement calculator to see how much you would save, before deciding whether your capital is better used to prepay or to invest and generate higher returns.
4. 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 said before that I love using credit cards compared to other payment methods.
However, as a loan, it’s ridiculous due to the way the interest is structured as well as the exorbitant interest rates.
If you don’t pay your credit card loan ASAP, you’d incur the interest rate wrath of up to 20% effectively (due to the daily compounding).
I don’t know any investments out there that provide more than 20% returns consistently, so I won’t hesitate to prepay this in full today. In my opinion, avoid getting into this loan in the first place!
The Ultimate Opportunity Cost
So, should I settle my loan early? To answer this question – it depends on what your opportunity cost is when you choose to prepay.
In my choices above, I won’t 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 you to use less capital to acquire an asset in exchange for paying an “interest rate”.
If I have RM100,000, I can use RM10,000 to pay for the downpayment of a house worth RM100,000.
I could borrow RM90,000 with an interest rate of 3%, but use this RM90,000 to invest into a REIT that pays out 5% dividend yield.
From this 5% return, I pay the loan of 3% and I still have 2% in returns that I can reinvest to get more returns.
Essentially, I own a house with RM10,000, and RM90,000 worth of REIT shares and generate a net return of 2% on the RM90,000, which will be compounded.
And this is without renting out the property. It’s a simple example, but it showcases the power of using loans the right way.
The other option is using RM100,000 to buy the house in cash. I now have a house and no cash or extra investments. Are you seeing what I see?
About the Author
This article was originally published at betweenthemoney.com, a personal finance website by Jason Loh that focuses on money matters and investment topics for Malaysians.
