Should one prioritise settling high-cost loans? It depends

Taking debt is easy, repaying it is not. One dilemma borrowers face is on deciding which loan to prioritise for prepayment. A common approach is to repay high-interest rate loans (such as personal loans, credit card loans, etc., which carry high interest rates) first, as it means getting rid of a high-cost loan. But is this always the right approach?

Ways to repay debt

The avalanche and snowball strategy are commonly used for debt repayment. The avalanche approach is to pay off debt with the highest interest rates first whereas the snowball method involves paying off small loans first.  However, just following these methods may not suffice in the case of multiple loans of different amounts, tenors and interest rates. These methods work well when the loans are of a similar nature as in the case of personal loans or credit card balances which are unsecured, short-term and high-cost ones. And the high outstanding balance and EMIs in the case of home loans as well as the long-term holding makes them unfit for either strategy.

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Tailored plan    

The best approach when one has both a home loan and unsecured loans is to create a custom plan. For this, first list down all the loans along with the tenure, interest rate and EMI. The prepayment amount can then be worked out based on the funds available and the EMI.

As an example, suppose an individual has the following loans:

The home loan is low on interest rate but has a higher interest outgo due to the long tenure and high loan amount. While it helps in asset creation, it comes with the burden of high EMIs. Personal loans on the other hand have high interest rates but the total interest outgo is lower due to shorter tenure and lower loan amount. As can be seen in the example, the interest outgo on a Rs 50-lakh home loan for 20 years is Rs 50.37 lakh whereas the interest paid on a Rs 5-lakh personal loan for five years is Rs 1.67 lakh. To decide which loan to pay off first, check the impact of the prepayment on the total interest.

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Which loan to close first?  

In the above example, with no repayment, the total interest paid for both loans totals Rs 52.04 lakh. Now assuming there are some funds available which can be used for repayment.

Following are the options:

Option 1: Close high-interest loan first

If the high-interest rate loan is to close first - The personal loan will be closed after the third year and from the fourth year pay two extra home loans EMIs (semi-annually). The total interest paid will reduce from Rs.52.04 lakh to Rs 41.05 lakh.

The effective interest saved is at Rs 10.97 lakh and home loan tenure reduced by 4.16 years.

Option 2: Close high-volume loan first

If the high-volume loan is to close first - The personal loan will be repaid and closed after scheduled closure in the fifth year. However, from the second year, two extra home loan EMIs will be paid. The total interest paid will reduce from Rs 52.04 lakh to Rs 38.25 lakh.

The effective interest saved around Rs 13.79 lakh and home loan tenure reduced by 4.9 years.

There is no single plan that works for all borrowers. In fact, one can use several strategies for paying off debt which can be mixed and matched to build a plan that works best based on the repayment ability. It is important to work with a financial advisor to understand the impact of different strategies and choose the one that works financially and emotionally too. The plan also needs to be realistic to execute. Closing the home loan first may be financially beneficial but having a high-cost loan may play on a person’s mind.  Finally, it is important for individuals to be clear about what will keep them motivated—whether it is saving the most money on interest or eliminating individual debts quickly.

The author is a financial educator, founder director of Finsafe India Pvt. Ltd and co-founder of Womantra

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.