Loans indeed boost our purchasing power, however, excessive dependence on it can often lead to debt trap and financial stress.
In a situation where a person has many loans, it becomes difficult for them to make a decision – which loan they should end first. As a result, they keep on contributing equally to all the loans. Doing this can negatively impact the finances in the long run. This is because it ends up paying more on the interest.
Here, one important question arises, “When should one close any loan? And which loan should be closed first (in case of multiple loans?)
Having a strategy for debt management plays an important role in minimizing the interest burden for a borrower. So let’s start with it-
Prioritizing Loan Repayments
Prioritizing your debts ensures savings and reduces your financial stress at the same time. To ensure this- it is advisable to follow these tips:
- Pay off the costliest loan first
- Calculate the overall borrowing cost of each of your loans.
- Find out the interest component of the repayment
- Pay your higher interest loan first
You can start by paying any credit card loan and personal loans first as these carry the highest interest burden.
Between Home Loan & Personal Loan which one should you pay first?
When you have too much debt to pay off including a personal loan and a home loan, it is important to have a debt repayment plan. This includes the following things:
- Type of loan (personal loan, home loan, car loan, credit card)
- The amount of loan and the amount to be repaid
- The interest rate for each loan.
Cost of Loan
Logically one should pay off the higher interest loans first. This includes paying off your credit cards and personal loans first.
Secured loans such as home loans have a lower rate of interest as compared to unsecured loans and hence, you can keep on paying them. Making pre-payments whenever you have funds can help you in closing them fast. Bonuses, incentives and lump-sum payment from your investments can be used to do so. And once the personal loan and credit cards are closed, you can focus on a home loan or any other secured loans.
However, it has also been seen that many prefer to close their higher amount of loan first. But this is not the correct path, to gain financial freedom and get out of the debt trap you need to do calculations and then take the final decision. Remember, closing the small accounts is never a good idea to deal with bigger problems.
Another important thing to consider is- Personal loans do not offer tax benefits. Home loans allow you a deduction of up to ₹ 1.5 lakh per towards repayment of principal and up to ₹ 2 lakh on the interest repayment. Moreover, these tax benefits can be availed for the entire home loan tenure. Availing these tax benefits not only reduces the income tax liability but also makes the repayment affordable. So, while closing your loans you should always consider the tax benefits associated with the loan.
Let’s understand this with an example:
Suppose someone is having – a personal loan of 2 lakhs, 1.5 lakhs outstanding on his credit card, and a home loan of 50 lakhs. The personal loan is at an interest rate of 10% p.a., for credit card interest he is being charged 18% and his home loan is 8.5%. The monthly EMI he is paying is- 25K for a home loan, 8k for a personal loan, and 7 k for a credit card. Now, as 25k is a much bigger amount compared to personal loan and credit card EMIs. So, he may decide to close the home loan first. But doing this will not be good for his finances. Closing personal loans and credit cards can save much of his money as the interest rate for them is high. And as soon as these closes, he can start saving for a home loan and start making pre-payments.
Interest rate is one of the important decision making parameters while closing any loan. However, you must not restrict yourself to the interest rate and check for other factors too. The total borrowing cost, tax benefits are some of the other factors which you can’t afford to ignore. Remember using an EMI calculator and analysing each of your loans separately and comparatively can help you.