Jean’s

Upon reading my last article on effective interest rate , a close friend of mine asks me a question: -

If Mr. A has RM 100,000 cash, should he: -

a)    Pay off his car loan of RM 100,000, with interest rate of 2% p.a. for 5 years; or

b)   Continue with his car loan, and save the RM100,000 in Fixed Deposit (FD), with interest of 3.75% p.a.,

This is a common question when one reaches a stage in which they have some money left over and wondering whether they should use the money now earmarked for savings to pay off their debt faster. 

In most instances, the answer is almost crystal clear by purely comparing the saving and loan respective interest rate. In the scenario that my friend gave me, almost without a doubt, Mr. A should place his money in FD (3.75%) while continuing to serve the car loan (2%). Let’s take this as his option 1: -

So, Mr. A will make a gain by saving the money in FD since FD is offering a higher interest rate than a car loan.

Let’s pause a little here and look from the other angle.  How about the monthly instalments that Mr. A would have to pay for the next 5 years to serve the car loan? What if, Mr. A paid off the RM 100,000 car loan, so that he is freed from paying the monthly instalment and hence have the extra same sum to save per month in FD. Would it be better off in term of net cash in flow?

Let’s see what can Mr. A make from this new arrangement: -

Hey, seems like the second option gives higher net cash inflow than the first’s – RM 11,159.00 vs. RM 10,209.98!

This just prove that sometime we can’t just look at interest rate at its face value, especially when it comes to car loan, which is a flat-rate loan, as I explained in my last article.  

If we were to look from effective interest rate point of view, car loan of 2% bear an effective interest rate of roughly 4% p.a. Hence it is indeed more costly as compare to the FD offered rate. Thus, it makes more financial sense to pay off the expensive car loan, and save the same instalment amount into FD monthly instead.

If you were to change the car loan interest to 1.5% instead of 2%, you will see that it will generate higher net cash in flow for Mr. A to opt for option 1 instead of option 2. Because 1.5% car loan will bear an effective interest rate of roughly 3% per year, which is lower than that offered FD rate of 3.75%. Hence, it will benefit Mr. A to continue with the car loan and have the RM100k saved in the FD. (for those who are interest to have the calculation spreadsheet, please feel free to contact me!)

Of course needless to day, it will only work as shown if Mr. A has the discipline to stick to his saving plan and invest or save his money wisely which likely yield higher than the loan interest. I too am under the assumption that Mr. A can pay off his car loan of RM 100k while still maintaining an adequate cushion of savings for any emergency needs.

What I am trying to say here is we might need to work out our financial plan from different angle rather than purely based on interest rate shown on the paper.