Many of us face this dilemma – “Should I use surplus money to pay off existing debt or should I invest?” It is not an easy decision to make. But give me an answer – why someone should take a car loan at 11% when his Fixed Deposits are just earning taxable 8%. 11% vs 6% tax-free (depending on tax slab) = –5% (on 5 lakh loan losing 25000 yearly) – it’s a simple calculation but I have seen n number of people doing this mistake. But in other cases calculations are not so simple…
My Sister’s Story
I am writing this because I want her to read.
Let me first clarify I don’t give financial advice to any of my relatives or friends – I don’t want to mingle personal & professional relationships. I advise them to get in touch with some financial planner or I connect them with someone. Even in the case of my sister I asked her to take help from some professional.
My sister & brother in law earn more than Rs 75 Lakh a year but are not able to save a fraction of this amount. I feel bad about that because I claim that I am doing something in field of Financial Literacy but my family members seem to be financial illiterate. (in hindi “diye tale andhera”) They are not spend thrift (at least they feel) but there problem is very common – LOAN.
A couple of years back they hired a financial planner (I recommended the name & I know he is good at his job) & he presented the harsh reality through the plan. They were not able to swallow what he recommended but still followed his suggestions for couple of months. But as they say old habits die hard – they soon lost the track & blamed the financial planner for that. (this is the irony of planners life)
Idea of this article generated from what they did this month. They prepaid (Rs 10 Lakh) part of their home loan – I should be happy about that but I am not. I have no doubts that they will feel relax as their debt burden is reduced but I know once this loan is finished they will go for another – property or car. I think they should have done the calculation before taking decision + also looked at other factors. Financial assets are must for survival & achieving goals.
Sorry Manya but it’s high time. 🙂
Steps to take and factors to consider before you make the right choice
List down your debts
List down all the debts that you have either in an Excel spreadsheet or on paper. Write down the debt amount, interest rate and duration for each loan. Indicate if any of the loans qualify for tax deduction. For example, if you have taken an education loan either for yourself or your spouse or child, the interest payable is eligible for tax deduction. The principal and interest amount in a home loan availed of is eligible for tax deduction.
Do you have an emergency fund
Check your cash and bank balance. Do you have money to take care of emergencies, unfortunate events like medical issues, job layoffs etc. The amount should be equivalent to 3 to 6 months of your expenses depending on your lifestyle and family situation. (if you are single bread winner go for 6 mths) If you do not have enough emergency fund, use some of the surplus amount to manage that.
Check the interest rates. Normally the personal loans or credit card debt have higher interest rates and are basically consumption oriented. It is best to pay off these loans first as the interest would only be eating into your savings account and you do not build any asset with these loans.
I got this email from citi bank – I don’t know any investment which can beat this rate.
Pay off strategy
You have to compare the interest amount you save when you pay off the loan versus the after-tax returns you generate (plus tax benefit on EMI) to decide whether it is better to pay off the loan or use it to save on tax. If you decide not to pay off, the surplus amount can be invested which will also give you returns or increase your wealth. If you take a home loan with the following details –
|Loan Amount||Rs. 20,00,000|
You will have to pay an EMI of Rs. 26,987 per month and over 10 years, it will be Rs. 12,38,440. If you have a surplus amount of Rs. 2,00,000, 2 years after the loan tenure started, you have two choices –
- You can pay Rs. 2,00,000 at that time. This will save you Rs. 2,32,000. But you will lose some amount eligible for tax deduction.
- You have the option of investing Rs. 2,00,000 in a large cap equity based Mutual fund, you could have earned returns around 10-12% and the total investment would be worth more than Rs. 3,20,000 (even if returns are taken at 12% p.a.). Though returns are not guaranteed, if you have the ability to take risk and tolerance for risk, you might be better off investing in equity mutual funds in this scenario.
So actually you have to do a calculation at your end that how much return I need to generate to beat what I am paying as interest. We have added a couple of calculators on our website – these can help you taking important decisions on loans. financial planning
But suppose it is a credit card loan, the interest rate is high and you have to pay other fees and you might end up having an expensive loan. It is better to pay off the credit card dues with the surplus amount.
It is important to consider your emotions. What do you like more – Being debt free or taking some risk by using the surplus to invest in some assets which might give you better returns. If you are not a good saver (my sister’s case) – it’s good to continue EMI (because it’s compulsory) & try hard to save (which is optional). THINK
You should know your risk taking ability and tolerance. Would you feel awful, if you realise later on that the equity markets or any other investment that you understand did very well and you would have made much more money investing there than paying off debt? Consider your personality and emotions before taking the decision.
Pay off debt Vs invest
To conclude, I would like to say that it is better to pay off debts that are costly to service. Paying off debt saves money. At the same time, it is important to invest in assets to generate returns and build wealth. You should use some of the surpluses to pay off loans like personal loans and invest the remaining amount in assets that give optimum returns depending on your risk profile and financial goals.
Pay off the smaller loans first so that you feel good about these wins.
Will love to hear if you have ever faced such dilemma.