Most of us would have availed loan for the purpose of buying House or Car or any other utility/service. Till such time we don’t have the money to repay it, we obviously keep paying the EMIs as per schedule. However there is a time when we might be having cash in hand to pay off the loan and there is a case to evaluate if you would be better off by paying the loan.
Factors to Consider before Paying off the Loan
The factors for consideration in this decision making would be as under:-
(a) Liquidity. One needs to be sure that he/she would be having enough liquidity to meet financial requirements/objectives in the next five years. If paying off the loan does not disturb this equation-then one can consider other factors.
(b) Tax Implications. Housing and Education loan come with some tax rebate. Loans without any tax rebate are costly and you may consider them for an to early payment. You should evaluate the Loans with tax rebate for their cost vis a vis opportunity cost (ie the cost of next best option).
(c) Cost of Loan. This is measured in terms of effective annual interest being paid. So for a car loan of 12%, the cost is 12%. For loans with tax rebate the interest cost is reduced with the marginal tax benefit to arrive at the effective annual interest. For eg if the Home loan is at 10% with tax rebate being 30% (marginal tax rate), then the cost would be 10 * (1-0.3) = 7%.
The Decision to Pay off the Loan
The Decision. Based on the outcome of the factor evaluation discussed above, one can decide on the beneficial option. Key deductions being:-
(a) Do not compromise on liquidity required in near future by making lumpsum payment.
(a) Pay off the costly loans first, which would generally be those without any tax rebate.
(a) Pay lumpsum only if the effective cost of loan is higher than the opportunity cost.