Meet Ben.
Ben is a 30-year old engineer making RM 8k a month. He has a car and a house.
He bought his car 5 years ago with a 9-year car loan worth RM 45k. He incurs as high as 3% in flat interest rate per year. Today, Ben’s loan principal stands at RM 23k and his car loan instalment is RM 529.17 a month.
Meanwhile, Ben bought his property 2 years ago with a 35-year home loan that was worth RM 350k. The interest rate is 4% per year. Today, Ben’s loan principal is RM 330k and his mortgage instalment is RM 1,648.22 a month.
Lately, Ben receives a 3-month bonus worth RM 24k. He plans to utilise them to pare down his debt. So, the question is: “Which of the two debts should Ben be paying off first? Is it his car loan or his home loan?”.
Here, I’ll be answering this question based on three angles:
- Their Effective Interest Rates.
- Impact to Ben’s Monthly Cash Flows.
- Impact to Ben’s Future Amount of Home Loan Eligibility.
Let’s begin.
1. Their Effective Interest Rates
Ben incurs:
- 3% in flat interest rate per annum on his car loan.
- 4% in effective interest rate per annum on his home loan.
Hence, to make a meaningful comparison, Ben should first convert the flat rate, which is 4% a year, into “effective interest rate” with the IRR formula. I wrote an article to illustrate how we can use Google Spreadsheet to make the conversion easily. Of which, 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, Ben would have paid “more interests” in his first 5 years worth of car loan instalments (Year 1-Year 5) than his remaining 4 years, which is Year 6-Year9. So, if Ben wants to know the effective interest rate, which he could save by settling his car loan balance of RM 22,972.48 (around RM 23k) in advance, the computation is as follows:
So, Ben’s effective interest rate that he would have saved is 5.01%. Still, the rate is higher than Ben’s 4% in interest rate. Hence, Ben would save more interests if he chooses to pay off his car loan balance of RM 23k.
2. Impact to Ben’s Monthly Cash Flows
Let’s start with Ben’s decision to pare down his home loan. If he does so, he can reduce his home loan balance from RM 330k to RM 306k. But, he is required by his banker to continue on his monthly instalments of RM 1,648.22. Therefore, if Ben chooses to reduce his home loan, the impact to his cash flow is “negligible” as Ben needs to continue paying both the car and home loan instalments.
But, if Ben settles his car loan, he would “free up” RM 529.17 in cash flows on a monthly basis. He could use them freely to:
- Invest (contribute to his EPF: 2022 dividends: 5.35%)
- Pare down home loan (save on 4% interest rate a year)
- Buy insurance (buff up his financial protection plans).
- Spend it in any way he deems fit.
3. Impact to Ben’s Future Amount of Home Loan Eligibility
Let’s assume the following:
- Banks allow one to service debts up to 60% of his monthly income.
- Every RM 1 in debt instalment is worth about RM 200 in home loan.
For instance, Ben’s monthly income is RM 8,000. Thus,
- The maximum debt instalment he can afford is RM 4,800 a month.
- The maximum home loan he can get is RM 960,000.
But, Ben has a monthly debt commitment of RM 2,177.39 (car + home loan). So for Ben, the amount of debt instalment he could obtain would be:
- RM 2,622.61 (RM 4,800 – RM 2,177.39)
- The maximum home loan he could qualify for is RM 524,522.
If Ben chooses to use the RM 24k to reduce his home loan, Ben would continue to service both his car and home loans totalling RM 2,177.39 per month. So, for him, the maximum home loan he can qualify for is still RM 524,522. There is no change on this amount.
But, if Ben chooses to settle his car loan in full, he would lower his commitment to RM 1,648.22 a month (home loan only). Thus, his amount of debt instalment which he could now obtain would be:
- RM 3,151.78 (RM 4,800 – RM 1,648.22)
- The maximum home loan he could qualify for is RM 630,356.
The increment is RM 105,834 in eligibility of future home loan amount.
Conclusion:
In short, if I’m Ben, I would choose to settle my car loan in full over reducing my home loan balance. I could save more interests, free up cash flow and also shall be able to increase my future home loan eligibility. Plus psychologically, there is a sense of achievement that comes from settling off a loan in full.
But, that’s my pick.
What about yours? Leave your comments below.
