Meet Ben, a 30-year old engineer who makes RM8,000 a month. He has a car and a house.
He bought his car five years ago with a nine-year loan worth RM45,000. He incurs as high as 3% in flat interest per year.
Today, Ben’s loan principal stands at RM23,000, and his car loan instalment is RM529.17 a month.
Meanwhile, Ben bought his property two years ago with a 35-year home loan worth RM350,000. The interest rate is 4% per year.
Today, Ben’s loan principal is RM330,000 and his mortgage instalment is RM1,648.22 a month.
Recently, Ben received a three-month bonus worth RM24,000. He plans to utilise this to pare down his debt. Which of the two loans should Ben pay off first?
Here are three considerations to help him make a decision.
1. Effective interest rates
Ben incurs a 3% interest rate per annum on his car loan, and 4% in effective interest rate per annum on his home loan. (The effective interest rate reflects the true cost of borrowing by taking into account the reduced principal balance over the loan tenure, and upfront processing fees charged.)
As such, to make a meaningful comparison, Ben should first convert the flat rate of 4% a year into an effective interest rate, which can be done using the Internal Rate of Return (IRR) formula.
By doing so, Ben would learn that his 3% in flat interest rate is equivalent to 5.5% a year in effective interest rate, which is higher than his home loan.
But, because of the Rule of 78 that stipulates a borrower must pay a greater portion of the interest rate in the earlier part of the loan cycle, Ben would have paid more interest in the first five years of his car loan than he would in the remaining four.
So, Ben needs to know the effective interest rate on which he could save by settling his car loan balance of RM22,972.48:
Ben’s effective interest rate on his car loan actually stands at 5.01%, which is still higher than the 4% interest rate on his home loan. Hence, he would save on interest if he chose to pay off his car loan balance.
2. Impact on Ben’s monthly cash flow
If Ben decided to pare down his home loan with his RM24,000 bonus, he could reduce his home loan balance from RM330,000 to RM306,000.
But, he is required by his bank to continue paying monthly instalments of RM1,648.22. Therefore, the impact to his cash flow would be negligible as Ben would still need to keep paying both his car and home loan instalments.
But, if Ben were to settle his car loan, he would free up RM529.17 monthly. He could use this to:
- invest or contribute to his EPF;
- pare down his home loan and save on 4% interest rate a year;
- buy insurance and buff up his financial protection; or
- spend it in any way he desires.
3. Impact on Ben’s future home loan eligibility
Assume banks allow you to service debts up to 60% of your monthly income, and that every RM1 in debt instalment is the equivalent of RM200 in home loan.
Given Ben’s monthly income of RM8,000, the maximum debt instalment he could afford is RM4,800 a month, while the maximum home loan he would be eligible for is RM960,000.
But, with his existing monthly debt commitment of RM2,177.39, the amount of debt instalment Ben could obtain would be:
RM4,800 – RM2,177.39
As such, the maximum home loan he could qualify for in future would be RM524,522.
So, if Ben chose to use the RM24,000 to reduce his existing home loan, he would continue to service both his car and home loans totalling RM2,177.39 per month.
The maximum home loan he could qualify for in future remains RM524,522, with no change.
But, if Ben chose to settle his car loan in full, he would lower his debt commitment to RM1,648.22 a month. Thus, the home loan instalment he could obtain in future would be:
RM4,800 – RM1,648.22
In turn, the maximum home loan he could qualify for next time stands at RM630,356 – an increment of a not insignificant RM105,834.
The bottom line
If you were Ben, you would be wise to settle your car loan in full over reducing your home loan balance. You would save on interest, free up cash flow, and also increase your future home loan eligibility.
Plus, psychologically, there is the sense of achievement that comes from settling off a loan in full, which should never be underestimated.
This article first appeared in KCLau.com. Ian Tai is a financial content writer, dividend investor, and author of many articles on finance featured on KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’ and ‘Small Cap Asia’ in Singapore.