THIS ARTICLE DISCUSSES the scenario for consideration in this series of presentations on using debt wisely: Is the statement, “Once you have the cash available, it is better to pay off a low interest loan than to hold cash”, true or false?
The answer is definitely, “it depends”. It depends on whether there are other loans of higher interest rates, on the age and stage of life of the borrower, on the interest rate on savings and investments, and on the borrower’s disposition to debt/risks for examples. Some persons abhor debt and wish to be debt-free at the earliest opportunity. Once the cash is available, they will pay off outstanding debt.
Consider a long-term loan like a student loan with a principal balance of $20 000 and an interest rate of four per cent. The borrower may find himself with, say, $10 000 from an inheritance and be considering paying down the student loan.
This borrower needs to consider a number of parameters that would guide this decision:
• Does he have a sound emergency fund? The standard recommendation is to hold three to four months’ expenses as an emergency fund.
• Can he earn a higher rate of return on an investment that the loan interest rate over his working life?
• How secure is his job; how good is his ability and capacity to earn in the long term? Related to this, how is his health?
• Does he have a retirement fund? Is he making the most of any matching funds his employer will make to his retirement fund?
• Is he uncomfortable holding debt?
• Would he rather enjoy some of his money now knowing he is likely to get salary increases, and bonuses in future from his job?
Even when the relative financial benefit of holding cash may be clearly demonstrated, the disposition of the borrower to risks and debt may be such that paying off the debt is the option chosen. In any event, it can make financial sense to pay off the debt as well as it can make sense to hold cash in similar circumstances for different borrowers.
For example, where the interest rates on an after-tax basis on savings and investing are higher than the loan interest rate, it may appear obvious to hold on to the cash. However, the particular borrower may dislike being in debt, maybe because he is in retirement and relatively cash rich already, or had set a goal to be debt-free by that particular age.
Alternately, for a younger person without an emergency fund, the preference may be to hold the available cash in establishing an emergency fund rather than paying off the loan. Establishing an emergency fund is fundamental. The fund serves as a strong measure in avoiding taking on even more debt when unexpected expenses crop up.
In the case where the borrower is paying down a loan like a mortgage or vehicle loan with available cash, the lump sum payment does not necessarily reduce the monthly instalment amount. So, there is the risk that if later on the borrower loses his job or is short of funds for any reason, that instalment must still be paid once there is a loan balance. The borrower may be forced to incur significant legal cost and time to refinance the loan in order to continue repaying the loan.
For younger borrowers who have the asset of a long horizon ahead of them, there is financial benefit in saving and investing extra cash rather than paying down or paying off a long-term loan like a mortgage once the after-tax rate on return on investing is higher that the loan interest. The compound interest effect over an extended period would generate an overall greater accumulated fund. Where the loan interest rate is higher than the investment return, the accumulated fund would be less.
Yet, ultimately, the choice to repay or pay down a loan with available cash is heavily influenced by the borrower’s disposition to holding debt and handling the risks of which he is aware.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. Email: Louisefairsave@nationnews.com
This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.
