Typically, if your savings are deposited / invested in options that provide you with a fixed return like your savings account or fixed deposits, what you earn on these savings is likely lower than the interest you would be paying on your loans. On the other hand if you are invested in potentially higher return instruments like mutual funds or stock markets, there is always the risk of volatility and your returns turning negative. Your debt, however, is costing you a fixed interest rate.
Simply speaking, if you have a loan and available savings, it is always advisable to use the savings to pay off your loans if the interest rate on your loans is higher than your earnings on savings (fairly likely). Having said this, it is worthwhile to also note that this rule may need to undergo mild variations depending on your personal debt vs. savings position as well as the nature of your loans/borrowings.
- What requires the most consideration is perhaps the argument for having a pot for emergencies. Most people would rather continue servicing a debt than dipping into the pool they might have accumulated for a rainy day. This argument can go either ways and it might help to take a simplistic example:
- Let us say, Mohan has an outstanding liability for Rs. 75,000 against a personal loan for which there are no tax benefits nor are there any prepayment penalties. He also has a savings of Rs. 75,000 which are in a fixed deposit earning an interest rate lower than what he is paying against his personal loan.
- If he continues this way he ends up making a net loss (Interest rate paid being higher than interest rate earned). If however, he repays the complete loan his savings are reduced to zero thereby reducing any financial security associated with these savings. Now let us compare these two options under two scenarios:
- Scenario 1: There are no financial emergencies requiring extra funds.
- If Mohan has not paid off his debt using his savings, he makes a net loss
- If Mohan has paid off his debt using his savings, he is better off because any savings that he manages from here on are actually creating a positive value.
- Scenario 2: There is financial emergency requiring Rs.75,000.
- If Mohan has not paid off his debt, he can use his savings for this emergency and is left with a continuing debt of Rs. 75,000
- If Mohan has already paid off his debt, he has no savings to meet this new requirement for funds and will have to borrow again which once again leaves him with a debt of Rs. 75,000.
- In other words, Mohan is in the same position under Scenario 2 irrespective of what he does. On the other hand, he was better off having repaid his debt if an emergency did not occur (Scenario 1).
- What the example shows is that the best outcome is probably to pay off your debts with your savings as long as you are assured of being able to re-borrow the cash if the requirement so arises. If not, you may want to continue with that pot of funds for emergencies.
- You may also want to keep in mind that different types of loans have varying levels of interest rates. Home loans and student loans are cheaper than car loans that are lower than personal loans which are a few notches below credit cards. Always prioritise eliminating the most expensive debt first. At the same time, make sure that any borrowing on account of an emergency is not going to be rates higher than what you paid off using your savings. After all, it may not make sense to repay a cheaper home loan with your savings, only to take a more expensive personal loan later in case of an emergency.
- Does the repayment of your loans come with penalties for any pre-payments or foreclosures as might be the case for certain category of loans such as home loans? In such a scenario, one needs to ensure that the penalty is not large enough to negate the elimination of interest burden. On the other hand, if your debt is outstanding credit card payments it makes complete sense to utilise as much of your savings as possible to reduce, if not eliminate this debt completely.
- Are there any tax benefits available on the interest payments against your loans – once again as available for home loans? If so, you might want to evaluate the tax advantage vis a vis the reduction in interest through repayments. Where the tax advantage is meaningful, you might want to continue
with the debt while using your savings for investment purposes.
The broad principle, therefore, has to be to try and repay or at least reduce your loans at the earliest.
- For large amounts that cannot be repaid in one go, manage your savings in a way that help you pre-pay the loan with intermediate payments so as to reduce your overall interest burden.
- In case of a continuing credit card debt, always endeavour to pay more than the minimum that is required so that you can recover from the debt faster than you would if you paid only the minimum amount.
- Make use of any ‘windfalls’ to lower your debt. Use at least a part of your bonuses and extra incentives that you might receive to repay your loans.
- What might also work is to follow a disciplined approach of putting away a certain defined percentage of your income into what you may consider your back-up for a rainy day and another defined percentage towards reducing your liabilities.
Like any other sound financial plan, your own personal balance sheet needs to avoid a situation where there is nothing left on the left hand side and nothing’s right on the right.