What should you do with windfall gratuity gains: Invest or pay off loans?

Dubai - Experts give handy tips to debtors amid hard times, where astute financial planning holds the key

The Covid-19 pandemic has forced a lot of us to re-examine our finances.

With uncertainty looming large over jobs and pay cuts disrupting harmonious monthly household budgets, there is always a question of whether to continue funding retirement savings or clear off debt first.

A debt-free living mostly affords more opportunities and possibilities, but then there is also the temptation to leverage low interest rates during such times to build assets.

Where does one draw the fine line and how should one go about making financial decisions that we are happy about in the long run?

Prioritising paying off debt as opposed to saving for retirement depends on several factors such as: debt to income (DTI) ratio, current retirement savings, and types of loans taken.

“DTI ratio is defined as total monthly debt payments divided by gross monthly income. If an individual has a DTI ratio of 20 per cent or less, h/she is considered financially stable and can choose to reserve gratuity money towards retirement. The central banks define a DTI ratio of 40 per cent or more in a situation of financial distress, in which case the employee is obligated to use his/her gratuity money towards paying off loans. If a decision is made otherwise, the persisting DTI of 40 per cent may hinder his/her ability to take any further loans,” said Vijay Valecha, Chief Investment Officer (CIO), Century Financial.

The age of an individual coupled with current retirement savings is also a vital factor influencing the decision to pay off loans or not. “A younger individual may choose to continue accumulating debt since he/she has higher human capital left to pay off debts in the future and would like to get the ball rolling on having some savings. Whereas an older employee should work towards disposing leverage to live stress free in the future,” added Valecha.

Another important factor to consider is the type of debt and interest rate charged on it. “Pay off the most expensive debt first — rather than trying to reduce the number of loans. Also, check the cost of early payment. Know if there are any penalties associated with early foreclosure, so that the total cost is correctly measured,” said Vishal Dhawan, a certified financial planner and Chief Executive Officer (CEO) of Plan Ahead.

So, what kind of a loan must be paid off first?

Credit card debt must always be cleared first, especially if you are simply paying the minimum amount every month. An outstanding of Dh10,000 can take more than a decade to clear off the loan and you will end up paying the bank or the financial institution about 2.7 times more than the original sum.

Secondly, don’t look at closing smaller loans first and keeping the big one. An honest assessment of which loan to keep should be based on the interest rate being charged. “One should be paying off their credit card dues and personal loans first. Secured loans such as home loans and vehicle loans can wait. While prepaying a loan, individuals often overlook the costs associated with it such as foreclosure fees. It may be tempting to close a high interest personal loan due to a sudden inflow of cash but the early settlement charges that will apply must be accounted for before taking such decisions. If cash flows permit, borrowers should try to part prepay or foreclose high-cost unsecured loans. Secured loans, especially home loans can be paid in EMI (equated monthly installment) in the long run as they are generally low-cost loans,” said Valecha.

Come to think of it, taking a debt is not always a bad move