Debt can be a double-edged sword in personal finance. While certain debt can be used as a tool to leverage and build wealth, at some point, all debt must go. Particularly debt that has been used for consumption, as this form of debt has no place in a constructive financial plan.
By eliminating debt, you are not only saving in interest costs but you also free up future cash flow. The regular repayments that were going towards that debt can be allocated towards other wealth building strategies.
The quickest way to eliminate debt is to make a lump sum repayment. A lump sum repayment involves making a one-off payment towards the debt, in addition to the mandatory minimum repayments you are required to make under the loan terms.
This one-off payment can be funded from a variety of sources and often comes from utilising windfalls such as tax refunds, bonuses, inheritances, or other unexpected cash inflows.
A lump sum repayment directly reduces the principal balance owed, thereby decreasing the overall interest accrued over the remaining repayment period. The result – you pay less interest and reduce the time it takes to pay out the remaining loan balance.
Example of a lump sum debt repayment
Meet Vicky. Vicky has a $33,000 car loan with an interest rate of 9% and minimum repayments of $550 per month. Vicky got a bonus at work of $10,000 after-tax and decided to use that money to make a lump sum repayment towards her car loan.
By doing so, she was able to reduce her outstanding loan balance from $33,000 down to $23,000. By continuing her current repayment plan of $550 per month, she will pay off her car loan 2 years and 9 months sooner and save a total of $6,752 in interest. This demonstrates how a strategic lump sum repayment can lead to substantial savings in both time and money.
Benefits of a lump sum debt repayment
The BENEFITS of lump sum repayments include the following:
- Quicker Loan Payoff: Lump sum repayments are the quickest way to pay off your loan sooner. Even a small additional repayment may provide you with significant savings over the life of your loan.
- Interest Cost Savings: A lump sum repayment will reduce the size of your loan and save on interest costs. Interest is typically calculated daily so the sooner you reduce your principal balance, the less interest you’ll pay over the remaining life of the loan.
- Improved Cash Flow: Paying out debt is essentially like buying back your cash flow. Once the loan is paid out in full, you will no longer need to allocate funds to repayments.
- Financial Discipline: Making lump sum repayments instils financial discipline and encourages responsible money management, fostering a healthy financial mindset for the future.
- Achievement: Watching your debts crumble can be immensely satisfying.
Risks of a lump sum debt repayment
The potential RISKS of lump sum repayments include the following:
- Opportunity Cost: By allocating funds as a lump sum towards debt, you are forgoing the ability to invest those funds, which may generate a higher return than the interest cost of your loans.
- Potential Fees: Repaying your loan earlier may result in break fees, penalty fees, deferred establishment fees, or early repayment fees. It’s important to contact your lender to understand these charges before proceeding. These fees could potentially offset the interest savings from early repayment.
- Payment Restrictions: Depending on your loan terms and conditions, there may be restrictions on the amount of additional payments that can be made to your loan. You need to be particularly warry of this with fixed rate mortgages.
- Addressing the Root Cause: Paying off debts with a lump sum addresses a problem in your financial life but may not resolve the cause. Changing financial habits is essential to prevent accruing similar debt in the future.
- Lose Access to Capital: Once a lump sum payment is made, you may be unable to get those funds back. If you need access to the money in future, check if your loan offers a redraw facility prior to proceeding.
If you think lump sum debt repayment is an appropriate strategy for you, we strongly recommend you speak with your Financial Adviser. They can help assess the appropriateness for your particular situation.
