Last Updated : Nov 19, 2020 09:08 AM IST | Source: Moneycontrol.com

Have too many loans? Here’s the order in which you must prepay your debts

Credit card dues and personal loans are the most expensive debts. You must prepay these first if you have a surplus


Dev Ashish

A loan-free life is what most people desire. But it is missed most by those who have multiple outstanding loans.

Consumerism and the inability to restrain oneself has resulted in many people opting for several loans at once. How? They have a big home loan followed by car loan, personal loan and the cherry of credit card outstanding on top of these debts.

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I am sure a person facing such a situation will feel bogged down with all his EMI commitments. His first priority will be to ensure that he pays the basic and regular EMIs every month without fail. But what if some surplus is left after making all the payments? What should he do then?

Deploying the surplus

Assuming that you already have an emergency fund in place, a thought can be given to the idea of pre-paying the loans. But what should you do if you have multiple loans? You pick and choose the ones to pre-pay. Let’s discuss this with a simple example.

Suppose a person has the following loans:

-Home loan of Rs 35 lakh at 7.5 percent: EMI Rs 30,000 per month

-Car loan Rs 6 lakh at 10 percent: EMI Rs 10,000 per month

-Personal loan Rs 3 lakh at 15 percent: EMI Rs 15,000 per month

-Credit Card dues Rs 1.5 lakh at 3 percent per month (Or 36 percent annually)

Now this person is regularly paying Rs 55,000 for EMIs of home, car and personal loans. He has a monthly income of Rs 1.5 lakh and regular expenses of Rs 75,000 per month. That leaves an additional Rs 20,000 per month.

For simplicity, let’s assume there are no on-going monthly savings commitments.

The surplus of Rs 20,000 per month can be used to begin pre-paying these loan outstanding. So, which loans should be paid off first?

The ones which have the highest rate of interest.

Pre-pay high-interest loans first

Credit card dues are the most expensive forms of debt. It is not advisable to pay just the minimum amount due on credit cards.

So, the surplus should be used to pre-pay credit card dues in full, even before thinking of the other loans.

And once the credit card dues are paid off, pick the next highest interest-bearing loan, i.e., personal loan at 15 percent. This should be followed by trying to prepay the car loan. But there is a little twist.

Even before you start the prepayment of any outstanding loans, you can even take another personal loan of Rs 1.5 lakh to clear the credit card dues in one shot. Why am I asking you to take another loan when your plate is already full? Because credit card interest rates are 36 percent or more while you can get a new personal loan at sub-15 percent easily. So you save a lot on interest that way. If the above approach is taken, then the loan portfolio will look like this:

-Home loan Rs 35 lakh at 7.5 percent: EMI Rs 30,000 per month

-Car loan Rs 6 lakh at 10 percent: EMI Rs 10,000 per month

-Personal loan Rs 4.5 lakh at 15 percent: EMI Rs 25,000 per month

-Credit Card dues, nil

So now, the surplus available will reduce to Rs 10,000 per month. And using the reasoning for paying off the highest interest rate loan first, you can now use the surplus to begin prepaying the personal loan every month.

I know many might be in a dilemma about paying off loans versus investing for the future. But it’s better to clear off the high-interest loans first before taking the investing route.

Home loans can be continued regularly, as they are very cheap and offer tax benefits for the borrowers. Car loan can also be paid off if the actual rate is high, else, it can also be continued for a while.

But if someone does not have an emergency fund in place, it is strongly advised to save some money for contingencies first. It might mean paying some extra interest, but so be it. Having an emergency fund is non-negotiable.

By the way, just note one more point with regards to the prepayment of home loans. It’s always beneficial to make home loan prepayments during the initial part of the loan when the maximum part of EMI is made up of the interest component. And, if you make part prepayment and then the lender gives you the option of either reducing the EMI or reducing the tenure, it’s better (for most people) to reduce the tenure and keep the EMI constant.

(The writer is the founder of StableInvestor.com)
First Published on Nov 19, 2020 09:08 am
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