Conventionally, early repayment of your loans is considered a good thing. This is because paying your loans in advance allows you to:
1) Save on interest
2) Access more cash with each paycheque
3) Qualify for another loan since you have a lower debt-to-income ratio
4) Have less mental stress since your debt is already sorted.
However, this isn’t always the case. Most loans come tagged with several caveats especially on early settlement. We look into the case of student loans taken out for tuition fees and assess the reasons why you should never pre-pay your university loans in advance.
#1 Opportunity Cost
It may not always make sense to pre-pay the entirety of your student loan. Although you may be saving on the amount of interest you have to pay for in your monthly repayments, you lose out on the interest to be earned when you leave your cash in the bank.
Most savings accounts in Singapore operate on a tiered interest basis. This means that you stand to earn more interest if you keep a higher balance in your account. If you study in a local university like NTU, NUS or SMU, the cost of your entire candidature ranges from at least $28,000 and up, which means an equivalent amount of funds in your bank account to be generating higher-tiered interest.
#2 Early Settlement Penalties
Some loan contracts include early settlement penalties or exit fees. For instance, Maybank’s education loan only allows changes to the agreed amount of the loan tenure if you pay a prepayment fee or an administrative fee.
Some interests are also pre-computed even if you are settling the loan ahead of the agreed loan tenure. Lenders calculate the amount of interest you’ll pay over the agreed loan tenure and add it to the principal amount due. This means that paying ahead will have no bearing on whether you save more money and you may even incur additional expenses that are unnecessary.
#3 Not Being Able To Enhance Your Credit Score
Ironically, taking your time to pay off a loan would contribute to building a healthy credit score, since it builds up a longer history of timely and responsible loan repayment. When you quickly (or immediately) repay your loans , it is considered a closed account on your credit report. This shortened payment history decreases the diversity of your credit portfolio.
While you do eventually have to close a credit account, a way of reducing its negative effect on your credit score is to ensure that you have sufficient payment history and existing open accounts.
#4 Cashflow Inflexibility
When you surrender a large amount of money to pay off your principal, you are taking away from your savings buffer. In the early stages of your career, the lack of a savings buffer may mean greater stress for you at work since you face cashflow inflexibility to make a job or career switch if you have the need to.
You may require the extra buffer of cash depending on your life stage as well. Your expenses invariably go up if you are about to get married or buy a house, and a savings buffer might be the emergency fund that you’ll need to tide you through this period of increased spending.
No One-Size Fits All
Of course, pre-paying your loan in full ahead of your loan tenure isn’t always the worst. In the case of paying using the CPF Education Scheme the accrued interest will have to be paid in full along with the principal amount. However, the interest accrued benefits the person who loaned you the amount as that would be the interest generated should the principal amount have been left in their CPF.
Additionally, having the funds restored in their CPF allows the CPF member to use the monies for investing, buying a property, drawing out for their retirement or earning the risk-free interest from the CPF Board rather than from you.