Compare paying off a loan early with saving or investing the same money.
Arjun's year-end bonus came to S$2,000 after CPF (an invented example), and two colleagues disagree about what he should do with it. One says to put the lot on his study loan, since debt is bad. The other says that would waste the money, since a 4.5% rate is cheap and markets have returned more than that over the long run.
Each of them sounds sure, but neither has asked about Arjun's savings, his loan terms or who lent him the money. You can settle the repay-or-invest question for yourself by going through four checks in a fixed order: buffer, early repayment fee, interest rate, and who the money is owed to. None of them has one correct answer. What you want at the end is a decision you can explain using your own rate, fee, buffer and reasons.
Arjun's loan comes from Lesson 5.1, "Bank study loans and the CPF Education Scheme compared". He borrowed S$20,000 at 4.5% a year, to be repaid over five years. His instalment is about S$372.86 a month, and across the whole five years the interest adds up to about S$2,371.62.
Picture him putting the S$2,000 into the loan at the end of month 12 while his instalment stays where it is. He would finish in 54 months instead of 60. Interest over the life of the loan would come to about S$2,002.08. Take that from S$2,371.62 and he keeps about S$369.54, plus six months without repayments.
Any amount you pay off early stops attracting interest for every remaining month of the loan. So a dollar sent to the loan earns exactly the loan's rate, and it earns it for sure, with no market risk and no chance of a loss. On a 4.5% loan, paying early is the same as getting a guaranteed 4.5% a year on that money. You can think of this as early repayment as a guaranteed return.
Invested money behaves differently. Over many years it might beat 4.5% or fall short, and in any one year it can drop. Setting the loan rate next to a figure for market returns does not answer anything by itself. The decision is whether a return you can't be sure of is better than one you can, for money you may end up needing. Lesson 5.1 of How money works, "Every place you put money trades risk, return and liquidity", sets out that trade-off.
Check 1 asks whether your buffer is ready. This is the emergency fund described in Lesson 4.3, "A buffer first: an emergency fund sized to your life", and it needs to be in place before any extra dollar goes to the loan. Once money is in a loan, getting it back is very difficult. A lender won't return it because you've lost your job, and your instalment normally stays the same after an extra payment, so your monthly bills don't shrink either. Pay early with no buffer and you owe less while holding no cash, which is the worst position to be in when something goes wrong. Build the buffer first and make extra repayments after, whatever rate the loan charges.
Arjun fails this check. When his laptop had to be replaced in March, it showed he has almost no buffer. His S$2,000 therefore goes into his emergency fund.
Check 2 is about fees and limits. Some lenders charge for paying early or paying off part of the loan, and some cap how often or how much you can pay on top of the instalment. Any fee cuts into the interest you save, and a big enough one leaves you with no benefit at all. The terms sit in the early repayment clause of the loan agreement; if they're unclear, ask the lender. With a CPF Education Scheme loan, the CPF Board website explains how extra payments are handled.
A higher rate makes repaying early more attractive. Keeping a high-rate loan costs a lot, and very few things pay that much with certainty. A low-rate loan costs little to keep, so paying it off early is mostly about peace of mind, and the maths adds little.
Rates in the middle, such as 4.5%, are where people disagree. Arjun's loan is in that band, which explains why his colleagues pointed him in opposite directions.
Make sure the rate you're judging is the effective rate. Put a flat rate beside an effective rate and the flat-rate loan can look cheaper than it really is. Lesson 3.2 of How money works, "Why a flat rate loan costs nearly double what it looks like", shows why.
The final check is not a calculation. CPF Education Scheme repayments return to the account that paid for the course, and that account often belongs to a parent.
Hui Min, who you met in Lesson 5.2, studied on money from her mother's CPF account. Each faster repayment puts her mother's retirement savings back sooner. Even if the interest saved is small, that can make repaying faster worth it for Hui Min.
For Arjun, the checks point one way for now: this year's S$2,000 fills his buffer, and next year's bonus goes to the loan.
Write down your loan rate, any early repayment fee and whether your buffer is in place, then decide if you will pay early and say why.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).