Should You Prepay That Loan?

This question arises when you have some extra income that you could use to increase your monthly debt repayments, or when you get lump sum income and are considering using it all to repay the loans you have.

There are many schools of thought about debt; some people believe debt should be avoided totally. They believe that you should buy only what you can afford to pay for in cash, and that one should live totally debt free. If you belong to this school of thought, then the sensible thing to do with any extra income you get is to pay down your debt. This is the ideal way to live, but we know life doesn’t always work out that way. We also know that debt is at times necessary and even advantageous. You can borrow to buy a car because it is a necessity as Muuguzi commented on this post. You could also decide to borrow to start a business or to fund a business once your savings run out like I did. Sometimes you need debt to complete your studies. These are few of the many instances when you may need to take a loan.

This post was inspired by a friend who asked me for advice on a loan he had. He asked if he should tighten his belt and prepay his HELB loan, or if he should pay it in the recommended small installments. As with all personal finance questions, there are no absolute answers but there are several factors you must take into consideration when making your decision:

1. Do you have an emergency fund? It does not make sense to prepay your debt if you don’t have an emergency fund in place. This is because when you get an emergency, you will be forced to borrow to meet that emergency, and emergency borrowing is often quite expensive. Ideally an emergency fund should cover 6 months worth of living expenses, though when trying to pay down debt, 3 months makes more sense and is easier to achieve. It goes without saying that you should have good medical insurance in place too.

2. What is the interest rate and what is the opportunity cost of prepaying? Sometimes it may make sense to invest your extra income instead of prepaying the loan. If you have investment avenues that are likely to give you returns that are higher than the loan interest saved, then invest the cash. Say for example you have a SACCO loan at 12%, and an opportunity to buy a corporate bond at 15% or even invest in a business that will earn you over 20% per annum, it makes sense to invest the cash, then use the returns to pay off the loan. When evaluating this, remember to include all costs of borrowing such as annual insurance, and all costs of investing.

3. Your earning prospects / economic predictors: When deciding whether to prepay or even take a loan, you should realistically assess your earning prospects. Is your current job stable? If you lose your job today, what are the chances of getting another one that pays the same or more than your current job? How long would it take you to get a job that pays the same if you lost your job today, and does will your emergency fund be sufficient to live on and repay the loan in this period. If your prospects are good, then it may make sense to save and invest the extra income instead of prepaying the loan.
Secondly, an assessment of interest rates trends is often helpful. If interest rates are expected the decline, then it makes sense to hold on to your loan. If the economy is inflationary and interest rates are predicted to keep increasing, then prepay your loan.

4. Prepayment penalties: Some loans attract penalties on prepayment. When considering prepaying, calculate the amount you will pay as a penalty and factor it into your interest expense to date, versus the interest you will pay if you hold the loan to full term. If the former is not significant, then it makes sense to prepay your loan.

Back to my friend, I did not give him a direct answer. I however hope that I gave him enough information to enable him make the decision. Have you ever considered prepaying your loan? What factors did you consider, and what was your decision? Let us discuss in the comments section.

Image Credits: SBM