Eliminating Debt in Various Types of Loans

A debt or loan is borrowed money obtained either from an individual or financial organisations such as banks, credit card companies, insurance companies, consumer finance companies and some government sponsored entity.

While companies and small enterprises use loans to grow their businesses, it can get out of hand when you don’t have the right debt management strategies in place.

Understanding your type of loan and its features allows you to plan your finances and make the most out of your debt.

Fixed rate loan: This loan has a fixed interest rate that protects you against rate fluctuations that can happen with a change of economic conditions. While this loan may shield you against rate increases, the interest rates are generally higher than loans that are not fixed.

This type of loan may also have limited features such as charging early payout fees when you want to accelerate repayment or settle your loan before it is due.

Variable loan: This type of loan does not have a fixed interest rate and may change periodically, resulting in changes in the amount of your loan repayment. Variable loans generally have lower interest rates than fixed rate loans and allow you to make additional repayments, vary payment frequency, use a redraw facility and offset facility.

Redraw facility: This is a loan feature that allows you to pay extra funds into the loan and redraw it later for other purposes. You can use this facility to reduce your interest payment and shorten the term of your loan.

Offset facility: Using a separate account as your loan’s offset facility allows you to offset the interest this account earns against your loan, which serves to reduce your interest liability. While you can withdraw funds from an offset account, this facility may only be an effective debt management strategy if you keep all the funds in this account, including all its income, for as long as you can to reduce the interest and term of your loan.

Financial counselors also distinguish between ‘efficient’ and ‘inefficient’ debt. Efficient debt is one used to purchase assets that produce income such as shares of stock or real property investment. It is considered efficient because interest payments made on this loan are tax deductible.

A loan can be ‘inefficient’ if it is used to acquire non revenue generating assets such as a home, car or holiday tour. The interest payment on this type is not tax deductible, making it inefficient from a wealth creation viewpoint.

When choosing which debts to reduce first, experts recommend reducing or eliminating inefficient debt because it will reduce your interest costs and potentially provide you with more cash flow which you can use to repay other loans or to make additional investments.