Many times, one must take a loan (personal loan, home loan, or auto loan) to fulfil various needs. Taking a loan is not always a bad idea. Without a loan, most people, for instance, would not be able to buy a car or home. But when taking any loan (personal loan, home loan, or auto loan), one has to make payments on time to pay it back. Failure to do so can result in several issues, including damage to one’s credit rating and future money troubles.
But the debt load can feel heavy if one has several loans to pay off. Therefore, in these cases, one must adopt a good strategy to repay the debt.
What are Personal Loans, Car Loans, and Home Loans?
A personal loan is a kind of loan that can be used to cover any expense. It is an unsecured loan. This means you don’t have to provide collateral to the lender to get the loan amount. Your financial eligibility decides whether you are eligible for a personal loan. Personal loan approval is based on your income and debt-to-income ratio.
A car loan, as the name implies, is a kind of loan that is only used to purchase a car. Unlike a personal loan, the loan amount can’t be used to fund other expenses. A car loan is a type of secured loan. Your car is used as security for the lender. The lender can take the car if you fail to pay your funds.
A home loan is a secured loan. It is used to purchase a property by using it as collateral. Home loans provide high-value financing at low-interest rates. They are paid back in instalments. You can receive ownership of the property after repayment.
Prioritising Loan Repayments
Settling debts in order of priority assures savings. It also eases one’s monetary burdens at the same time. Here are some pointers:
- The person should clear the most expensive loan first.
- One should estimate the total borrowing costs for each of their loans.
- One must learn how much of the repayment will include interest.
- One should pay off the loan with the higher interest rate first.
- Since personal loans and credit card debt have the highest interest rates, one can begin by paying them off first.
Some Factors to Consider Before Deciding Which Loan to Pay First
There are many factors to consider before deciding which loan to pay first. These are as follows:
Pay Off The Most Expensive Loans First
The basic rule is that one must first pay off the most expensive loan. It means the person should pay the loan with the highest interest rate. This saves them money on interest.
The annual interest rate on a personal loan ranges from 14-18%. The loan’s term is usually limited to five years. Auto loan interest rates range from 10-11% per annum with a maximum term of seven years. The interest rate on education loans ranges from 10-18% per annum. Home loans are the most cost-effective. They have interest rates between 9.7% and 11.5%.
If interest rates were the only factor, personal loans would need to be repaid before loans for education, cars, and homes.
The Income Tax Department offers fair responses to home loans and education loans. Under Section 80C, principal repayment on a home loan for a self-occupied property up to Rs. 1.5 lakh is tax deductible. Under Section 24, there is an extra deduction for interest costs of Rs. 2 lakh.
The total interest payment can be deducted from rental income for an asset that has been rented out (as opposed to a self-occupied property). With these tax benefits in place, a person in the highest tax bracket could reduce the actual cost of a home loan (20 years) to as little as 7.2% per annum.
Tax benefits for auto loans are only open to self-employed people. Such loans’ interest charges may be deducted from their taxable income.
If one decides to prepay their loan, a clause in their loan agreement may clearly state that they must pay the penalty. There is no prepayment penalty for floating-rate loans. But prepayment penalty clauses may be present in fixed-rate loans. It includes fixed-interest rate loans.
The person’s loan agreement will include exact details. Other fees, like processing and prepayment, might be checked too.
Pay Off a Loan On a Decreasing Asset
Some experts state that loans held by assets that would lose value should be paid off first. A few loans, like one taken for a trip abroad, don’t build any assets. Such loans include auto loans and other types of vehicle loans.
For instance, if one’s car has an auto loan for Rs. 5 lakh and its market value is Rs. 4 lakh, they won’t be able to pay it off even after they sell it.
If one has a property that is appreciating (or does not lose value quickly), like a house, one can at least sell the property if they are under financial stress.
Invest or Prepay?
A common query is whether to invest the extra money to earn higher returns or prepay a loan. The basic rule of finance states that one should invest rather than prepay a loan if they can earn a return greater than the cost of their most expensive loan. One can’t avoid making interest and principal payments, but the returns on their investment are not certain.
Many monetary products assure returns in advance, like fixed deposits. But the returns from such products will be lower than the actual interest rate on any of their loans. With the extra money, one should prepay their loans.
The interest rate is the most crucial deciding factor for paying off any loan (personal, home or auto loan). One should not limit themselves to the interest rate given in the loan agreement. The person should try to find out the actual interest cost after considering tax benefits. They should compare potential interest savings with the cost of any prepayment fees. Once the person has done that, he should pay off the loan with the highest interest rate.
One can visit Piramal Finance for more details on the type of loans one should pay first. They can also explore their products and services.