One of the more frequent questions people ask is whether or not to use a lump sum to pay off debt. For example, you may have R100 000 sitting in a money market account earning 6%, providing an income of R500 per month.
At the same time, you have a 48-month loan of R200 000 at 16% per annum with a repayment of R5 670 each month. You could use the R500 income from the money market account to supplement your debt repayment, but it would make more sense to pay a portion of that lump sum to settle some of the debt as the interest you earn from the bank is less than what you are paying the bank.
If you have no emergency savings, a good strategy would be to keep some funds for an emergency and use the rest to accelerate your loan repayment.
For example, you could keep around R40 000 in a high interest-bearing account which will ensure that you do not have to take out more debt in the case of an emergency.
You could then use R60 000 to accelerate the loan repayment.
If your loan is R200 000 and you settle R60 000 with the lump sum, you have two options.
- Reduce your repayment from R5 670 to R3 960 per month over 48 months – this will reduce your total repayment by over R81 000.
- Keep your repayment at R5 670 per month, which means you will settle the debt within 24 months – this reduces your repayment by R136 000 which is more than double the R60 000 that you used to accelerate the loan repayment.
In comparison, if you had left that R60 000 in the money market account, it would only have grown to R76 000.
The higher the interest on the loan, the bigger the impact the extra R60 000 payment would have on the debt repayment.
So, the answer to the question of whether you should use a lump sum to pay off a debt, is a definite “Yes”, but always keep something aside for emergencies.