Should You Always Repay Loan Early

by: Stephen Nelson


But you can't look just at the interest savings. If you placed the same $20 a month into a money market fund, purchased savings bonds, or invested in a stock market mutual fund, you would also accumulate interest or investment income.

How can you know whether early repayment of a loan makes sense? Simply compare the interest rate on the loan with the interest rate (or investment rate of return) you would earn on alternative investments. If you can place money in a money market fund that earns 6 percent or repay a mortgage charging you 9 percent, you'll do better by repaying the mortgage. Its interest rate exceeds the interest rate of the money market account. But if you can stick money in a small company stock fund and earn 12 percent or repay a mortgage charging you 9 percent, you'll do better by putting your money in the stock fund.

One complicating factor, however, relates to income taxes. Some interest expense, such as mortgage interest, is tax-deductible. What's more, some interest income is tax-exempt, and some interest income isn't tax-deferred. Income taxes make early repayment decisions a little bit complicated, but here are four rules of thumb:

If you're a business owner with the ability to invest additional funds in the business—and that investment will produce extra profits—you should usually make this investment first. Investments in small businesses often return 20 percent to 30 percent annually. If you can get that sort of return, every other opportunity pales in comparison. Note that in Chapter 14, I describe how to estimate the returns you receive from business investments.

Usually, if you have extra money that you can tie up for a long time and can't invest additional money profitably in your business, you'll make the most money by saving your money in a way that provides you with an initial tax deduction and where the interest compounds tax free, such as a 401(k) plan or an IRA. (Opportunities in which an employer kicks in an extra amount by matching a portion of your contribution are usually too good to pass up—if you can afford them.)

If you've taken advantage of investment options that give you tax breaks and you want to save additional money, your next best bet is usually to pay off any loans or credit cards that charge interest you can't deduct, such as credit card debt. Start with the loan or credit card charging the highest interest rate and then work your way down to the loan or credit card charging the lowest interest rate. For this to really work, of course, you can't go out and charge a credit card back up to its limit after you repay it.

If you repay loans with nondeductible interest and you still have additional money you want to save, you can begin repaying loans that charge tax-deductible interest. Again, you should start with the loan charging the highest interest rate first.

Understanding the Mechanics

Successful saving relies on a simple financial truth: You should save money in a way that results in the highest annual interest, including all the income tax effects.

It's tricky to include income taxes in the calculations, however. They affect your savings in two ways. One way is that they may reduce the interest income you receive or the interest expense you save. If interest income is taxed, for example, you need to multiply the pretax interest rate by the factor (1-marginal tax rate) to calculate the after-income-taxes interest rate. And if interest expense is tax-deductible, you need to multiply the interest rate by the factor (1-marginal tax rate) to calculate the after-income-taxes interest rate.