Loan Payment Strategy
Lately, while browsing various forums, I’ve repeatedly come across a question about investing and debt.
The question is a variant of this basic scenario: I have X years left on my loan, at around X% interest per year. But I can pay off the remaining amount (ex: 500,000 or more). Should I pay off the loan or is it a good idea to invest the money instead? (P.S. I also have the capability to make the monthly payments, separate from the lump sum I have right now.)
What would be a good strategy in this case?
Personally, my advice is to first consider your emergency fund. If you don’t have an emergency fund yet, consider making that lump sum your emergency fund rather than paying off the loan. Why? Because if an unfortunate situation arises and you have no emergency fund, you might end up borrowing money again.
If you do have a sufficient emergency fund, check if you will be able to save money by paying off the loan early. It’s always good to pay off loans as soon as you can. But depending on whether you can save money or not by paying early can significantly change your strategy.
If you will not be able to save any money, here’s what you can do:
- From your lump sum, take three months worth of monthly payments and place it in a savings account.
- With the remaining money, practice Laddering and place them in different Time Deposit (TDs) accounts (3 months, 6 months, 9, months, 1 year, etc.).
- Make sure that a time deposit will mature after you use the 3 months you put in a savings account and before the next payment is due.
- Create accounts in different banks to take full advantage of the 500,000
PDIC insurance and to make sure even the interest is insured.
- If interest rates are low, you can opt to not invest in time deposits with maturation dates of 1 year or more. Instead keep cycling in short-term TDs. Be warned though that it’s possible that interest rates go down again, so you could be making less money.
Why this strategy:
- Your money is insured, there is no risk of losing it. So there’s no danger of not being able to pay off the loan.
- It’s earning interest. Since you’re not saving money by paying off the loan early, at least you are making money from it with the interest.
- If an emergency arises that is more important than the loan payment, you can use your money; perhaps your emergency fund is not enough, or maybe to refill your emergency fund.
It can be tempting to invest the money in something that can earn more money. But all other investments that earn more than time deposits carry risks. What if your next payment is due and your investment is suffering a loss?
If you will be able to save money, compute the percent of the money you will be able to save. For example if you can save 2.5% in interest payments by paying off the loan now, and you can find a safe investment that will give you more returns than the savings, then go ahead and invest the money.
But the risk here is investing in something that can suffer a loss, and having to withdraw while your money is in the red. And loan interests are usually hefty, and so the savings on interest payment might be 5% or more. So it’s going to be difficult to find a safe investment with that much return.
The safest option, should all the above scenarios not be feasible, is to pay off the loan and invest the savings. At least that money can be invested in stocks, forex, bonds or any other investment vehicle you’re familiar with.
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photo credit: Philip Taylor PT via photopin cc