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3 Questions To Help You Decide If You Should Pay Off Your Loan

Updated: Feb 15, 2022

The idea of debt makes many people very uncomfortable. So many people just can't wait to get rid of it. Essentially clearing the debt means you get certainty. You know you own more of something without liability. You know you just reduced the amount of interest paid to the lender. However, it also means there potentially might have been an opportunity cost. You have lesser funds for other purposes because you used your money to pay off your loan either partially or in full.


This dilemma of whether 'should I' or 'should I not' is very common when it comes to the issue of clearing debts. Here are 3 guiding questions that can give you clarity on your decision making.


1. Is this excess money or Cash that make up your emergency funds?

The idea of decision making hovers around opportunity cost. Doing one thing means not being able to do another thing sometimes. Assuming you would like to pay off a $100,000 debt on your mortgage, is this $100,000 part of your 6 months emergency funds?


I've seen cases where people have saved up a substantial sum of money only to hurriedly try to pay off their mortgage thinking they want to clear their debt as soon as possible. However, doing so also means clearing out their 6 months emergency cash which might leave them in limbo if something unexpected happens like if their parents suddenly get retrenched and they need to contribute more to the household. If a scenario like that might cause financial distress such as defaulting on fixed commitments, then perhaps the lump sum on hand might not be the right time to pay-off the debt. If you are really bothered by the interest rates, you can consider other options like partial repayment or refinancing.


2. Are you planning to make another purchase in the next 1 to 5 years that require you to take up a new debt?

I've also seen cases where people pay off their mortgage loan at 1.8% interest and a year later purchased a car taking a loan similar to the lump sum they paid off at an interest rate that was above 2%. Then if that's the case, it might have been better to use the lump sum saved up to pay for the car without loan than to clear the mortgage.


It makes sense to pay off some mortgage if you are confident that the interest savings will enable you to save fast enough to cover your new purchase or take a smaller loan such that the difference between the loan cleared and the new loan still give you cash savings.


3. Are you able to get a better return on the money?

Assuming you currently have a debt that charges you a certain percentage for example 2.88% for a renovation loan. It's always tempting to clear the debt however, what if you are investing your money and getting a return of 5%? Would clearing the debt still make sense?


It might make sense to clear the debt if you are worried about the risk that the market will under-perform and you like the certainty of the debt cleared. However, there are many instances where it can be as simple as people simply have money in their bank accounts and they just want to clear the psychological uneasiness of having a debt. Sometimes, the savings accounts (eg: OCBC 360 account, UOB One account, DBS Multiplier, etc) they have give them more interests than the debt itself! So what's the hurry? You can always clear the debt after the interest rates drop.


Summary

My point? Paying off debt should be a case whereby it puts less financial strain on you, not create a situation where you are worse off. Of course, if you have debts charging sky high interests rates which is affecting your cash flow and ability to take up commitments that improve your life, you should clear it as soon as possible.


Unsure if you should pay-off your debt or not? drop me a message and I can see if I can help you get more clarity.


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Disclaimer: The content created are based on my personal opinions and may not be representative to everyone or any organisation. If you have any doubts or queries pertaining to insurance or investment, please seek professional advice from a trusted adviser in an official setting. You may also reach out to me if you do not have a present adviser using the message box under 'Let's Talk'.

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