Clear loans first then start a savings plan
The Sunday Nation
Nairobi,
04 September 2011
After reading the
articles about saving money, Agnes asks a seemingly straight-forward
question: “Is it worth maintaining a fixed deposit while servicing a
bank loan?”
Unfortunately, Agnes does not say how much money
she has in the fixed deposit account nor does she say the loan amount or
the interest rates applicable in both cases. But we can work with some
typical figures.
Suppose Agnes has a Sh1 million loan repayable
in five years at 15 per cent per annum interest. The monthly instalment
on this would be about Sh23,800 and so, in five years, she will have
paid a total of Sh1,428,000. The accumulated interest is Sh428,000.
Suppose further she has Sh500,000 in a five-year
fixed deposit earning a respectable 5 per cent per annum. The return on
this investment comes to slightly over Sh2,000 per month.
Assuming that the interest is compounded on a
monthly basis, it turns out that at the end of five years she will have
about Sh641,000 in the savings account. The accumulated earnings are
Sh141,000.
In summary, Agnes has paid Sh428,000 for the
loan but also earned Sh141,000 from the fixed deposit. The net cost is
simply the difference between these two amounts, that is, Sh287,000.
Now let’s look at the situation in a different
way. We know that Agnes needs Sh1 million. What if she removed the
Sh500,000 from the fixed deposit and then borrowed another Sh500,000 at
the same rate as before?
The monthly instalment now comes to Sh11,900
which accumulates to Sh714,000 in five years. The total cost of the loan
is Sh214,000. So, even though Agnes doesn’t earn anything in this new
arrangement, the total cost is still less. Therefore she is better off
withdrawing the money from the fixed deposit account and taking a
smaller loan.
What if Agnes didn’t have the Sh500,000 in the
fixed deposit account but could save the money slowly over the five-year
period?
Assuming she can convince the bank to pay the
same 5 per cent rate, she would need to save Sh7,350 each month to reach
this target. At this rate, she will actually have deposited Sh441,000
and earned Sh59,000 as interest to make the desired Sh500,000.
So at the end of the five-year period, she has
cleared her loan and has managed to accumulate Sh500,000 in a savings
account. That looks quite good: she has taken and repaid the Sh1 million
loan and still has a decent balance in the savings account.
But, instead of saving the Sh7,350, what if she
added it to the monthly instalments of the loan? That would clear the
loan in about three years and five months. After clearing the loan,
Agnes can easily commit to save the Sh31,150 for the remaining one year
and seven months until the expiry of five years.
Assuming that she can get the same five per cent
interest as before, she will have accumulated Sh615,000. This is better
than the Sh500,000 accumulated in the previous case.
Therefore, whichever way we look at it, she is
better off clearing the loan before starting to save.
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