Which loan should you close first? Bigger one or the costlier one?

Loans are inevitable when one seeks instant gratification with limited resources. The credit cards and personal loans make life simpler for most millennials looking for instant solutions. Add a large home loan or a vehicle loan and the individual realises that he is getting into a debt trap. Naturally the first question that comes to his mind is which loan should he pay off first?

“Logically one should pay off the high cost loans first. To put it straight you should be paying off your credit card dues and personal loans first. Secured loans such as home loans and vehicle loans can wait,” says Rohit Shah, founder of GettingYouRich – Mumbai based financial planning firm.

Most of the times the individuals want to either pay off the large loans or small loans. Some individuals are keen to close the small accounts and some want to deal with the ‘large problem’ first. However, as per the financial planners the size of the loan is not as important as the cost of the loan. This can be best understood with an example.

Say you have got a performance bonus of Rs 1 lakh and you have two loans of Rs 1 lakh each. One attracts a rate of interest of 18% and the other one is priced at 8.5%. The first loan, if repaid today instead of repaying over 12 equal monthly instalments, will save you Rs 10016 which you have paid towards interest. The second loan, if repaid today instead of repaying over 12 equal monthly instalments will save an amount of Rs 4664 towards interest.

“Always pay off high cost loans such as credit card outstanding and personal loan first, as they eat up your earnings. Typically one’s income grows at a rate of 8% to 10% per year. The high cost loans charging double digit interest act as a drag on your money matters,” explains Chetan Bhatia, a financial planner based in Mumbai.

Though it appears to be a simple idea to pay off the high cost loans first, there are many practical difficulties one has to face. “Sometimes individuals are forced to pay off the gold loans, as the family wants the gold jewellery back,” points out Rohit Shah. Though the gold loans are typically cheaper than many personal loans, an individual may be forced to repay the gold loan first and bring home the pledged family gold. In such circumstances, one can do little, but to buy peace of mind by foreclosing gold loan. But once that is done he should go back to chase the high cost loans.

You should also keep in mind the costs of closing a loan, says Rohit Shah. Consider a situation, you are cash starved and suddenly you hit on some cash inflow of Rs 2 lakh. In such circumstances, it is tempting to pay off a high cost personal loan charging you 18% per year. But wait a minute. First assess the overall situation and near term needs. If you pay off your loan now, you will have to pay the foreclosure charges too. Also it will nullify the cash balance. If you need money to overcome some emergency in near future, you will have to go for another personal loan. That new loan will make you pay for processing fee and other charges in addition to the efforts of taking the loan.

Hence it makes a lot of sense to assess your financial situation before targeting your loans. “If your cash flows permit, you should try to part pre-pay or foreclose high cost unsecured loans. Secured loans- especially home loans can be paid in EMI in long run as they are generally low cost loans and they bring in tax breaks,” says Bhatia.