The Debt Panel: ‘Will I be penalised for paying off a car loan early?’

The Dubai reader wants to be debt-free but is seeking advice on whether it is better to invest the lump sum

Getty / Nick Donaldson

I am halfway through a four-year car loan of Dh50,000 ($13,614) that I took out in 2021. I haven’t missed any instalments but am now in a position to pay off the loan in full.

However, before I do this, I wanted to find out if there would be any penalty imposed for paying the loan off two years early.

I am also concerned about rising interest rates and if this will affect my monthly car payments for the next two years if I continue to pay it off — or is it a fixed rate from the date of the start of the loan?

I would rather not be in debt and would prefer to own the car outright.

Can you advise me on the best solution — should I continue with the loan repayments or pay it off in full? Or would it be better to put the lump sum into a higher interest account or invest it? EG, Dubai

Debt panellist 1: Steve Cronin, founder of DeadSimpleSaving.com

Well done for being in a good financial position and able to pay off your loan. It seems like you will soon be debt-free and able to focus on saving and investing.

You will have to pay a repayment fee, but the UAE Central Bank has capped it at 1 per cent of the outstanding balance.

For example, if you have Dh25,000 outstanding, you will have to pay Dh250. That would definitely be cheaper than paying interest for another two years.

You have said that you don’t want to be in debt, and that your personal feelings around debt are an important consideration.

Some people hate debt and lose sleep over the risks and administration involved. The answer for them is always: Pay it off if you can.

However, there are other options if you are keen for your money to work as hard as possible towards your financial independence.

As you rightly point out, you could invest the money instead or save it. How to decide?

Interest rates are the deciding factor for me — is your debt relatively cheap or expensive?

In the stock market, you can expect your money to grow by about 7 per cent annually over the long term (from year to year, the return can be all over the place).

So, if your car loan’s interest rate is below 4 per cent, then that is pretty cheap. You are probably better off keeping the car loan and investing the money instead.

However, if your interest rate is above 5 per cent, that is a bit too close to the stock market’s 7 per cent return and you are probably better off paying down your loan instead.

Unfortunately, loan rates have gone up a lot in the past year, so loans below 4 per cent are increasingly rare.

There is a trap here. Car loan interest rates are often advertised using the “flat rate”, which is the interest rate on the initial loan balance.

However, you want to compare the interest rate on your remaining balance two years later. For that, you want the “reducing rate”, the rate you actually pay on the remaining balance as it reduces over time.

You can estimate the reducing rate by multiplying the flat rate by 1.85 or look up a flat-rate-to-reducing-rate calculator online. Flat rates are much lower, which is why banks use them for marketing their loans.

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If your loan rate and monthly payments were going to be affected by rising interest rates, you would have noticed by now. If your monthly payments are constant, then they should be fixed for the remainder of your loan.

One reason to delay investing is if you do not have much cash.

Make sure you have at least six months’ total expenses as a cash buffer for emergencies or job loss.

If you are significantly under that, then prioritise building your cash buffer over paying off cheap debt or investing.

If your debt is expensive, then you will have to juggle paying some of it off with making sure you have enough cash.

Debt panellist 2: Carol Glynn, founder of Conscious Finance Coaching

Congratulations on being in a position to pay off your car loan in full. It is always a good feeling to be debt-free.

The terms of your loan agreement should outline any penalties for early repayment.

Most lenders do charge penalties for early repayment, while others do not.

So, it is essential to read the terms and conditions of your loan agreement carefully or consult with your lender to confirm whether there are any penalties for early repayment.

Regarding your concern about rising interest rates, if you have a fixed-rate loan, your monthly payments should remain the same throughout the loan's term, regardless of any changes in interest rates.

Visiting the UAE: a guide to renting a car — in pictures

The price of renting a car in the UAE will vary depending on the car you rent. Some luxury cars can be rented by the hour. Silvia Razgova / The National

There may be extra charges such as paying Salik, the toll fee, on some roads. AP

Tourists need to provide a copy of their driving licence and passport when they hire a car. Victor Besa / The National

Companies usually take full payment for renting out the vehicles and block between Dh1,000 and Dh4,000 on the customers' credit card as a guaranteed amount, in case they commit any traffic offence. Getty

Tourists involved in an accident face the same rules as other drivers, which may include a visit to a police station or a court in serious cases. Mike Young / The National

Not all companies allow hired cars to cross the border into Oman, so check before travelling. Silvia Razgova / The National

However, if you have a variable-rate loan, your monthly payments may fluctuate if interest rates change.

Most car loans carry fixed interest rates but, again, you will need to check the terms and conditions of your loan agreement.

Should you continue with the loan repayments or pay it off in full? This depends on the interest rate you are paying on the loan versus the interest rate you can earn by investing the lump sum elsewhere.

If the interest rate you are paying on the loan is higher than the interest rate you can earn by investing the lump sum elsewhere, then it would be financially beneficial to pay off the loan in full.

However, if the interest rate on your car loan is relatively low and you can earn a higher return by investing the lump sum elsewhere, then it may be more beneficial to continue with the loan repayments and invest the lump sum elsewhere.

If you do invest, you should consider if you are likely to achieve a return higher than the interest you are paying on your loan

Carol Glynn,
founder of Conscious Finance Coaching

A good rule of thumb is if the interest rate is more than 10 per cent, then paying it off is wise.

If it is less than 10 per cent, you can consider other factors such as the length of time you plan to stay in the UAE, how much you dislike having debt and if you are in a position to start investing now.

If you do invest, you should consider if you are likely to achieve a return higher than the interest you are paying on your loan.

Ultimately, the decision of whether to pay off the car loan in full or continue with the repayments and invest the lump sum elsewhere depends on your personal financial situation and goals.

I would recommend evaluating your options by gathering information on the loan terms from your bank, investigating the investing options open to you and then making an informed decision based on your specific circumstances.

The Debt Panel is a weekly column to help readers tackle their debts more effectively. If you have a question for the panel, write to [e-mail]