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.
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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.
Calculate
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 |
| Interest rate | 10.50% |
| Tenure | 10 years |
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.
Calculators
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.
Emotional Aspect
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.
Hello Sir,
Great article.
I am in same dilemma. I do have an oustanding home loan of 11 Lakhs with interest 11.75%. Since I fall under 30% tax bracket, I am saving around 35,000/- in tax by continuing the loan. So my effective interest is around 92,000/- per year for a loan of 11 Lakhs.
My dilemma is : where should I invest the surplus 12 Lakhs that I have in FD.
– Equity Mutual Fund : Markets are already high. So still investing via SIPs in small amounts.
– Real Estate : Property prices are at its peak in Pune. Dont think this is the right time
– Gold : Doesn’t look like an investment anymore.
Any suggestions ?
– Manoj
It is apparent that you have been still paying effective interest Rs 92,000 after saving tax just Rs 35,000 per annum. Since you have had already the surplus of Rs 12 lakh in FD, you can make easily full pre-payment of your loan and become debt free immediately rather than investing in SIPs. After paying full payment of loan, you can start your monthly SIP equivalent amount with already paying EMI. While doing so, you would lose tax saving Rs 35,000 and save interest expenses of Rs 92,000 and can generate a sizeable corpus of Rs 35 lakh with monthly SIP of Rs 15,623 in the next 10 years while assuming return @ 12% p.a.
Well i had taken a vehicle loan of RS 10 LAKHS on 20/02/2014 @ 11% interest,
However till date [ one year five months] i have completed almost 90% of my loan amount including intrest, & the balance remaining is RS 1.03 lakhs which i plan to complete i the next two months.
This was the only loan taken by me.
Do you feel i have done the right thing
In my view, it is always better to pay off a loan taken for a depreciating asset.
I was in same dilemma some time back. I was having an outstanding loan of 13.5 lakh in 2014. Interest rate 12.00 %.
Since last year i have repayed 7.5 lakh and invested same amount in mf via sips. This strategy has done great for me so far. This year i am not planning to repay any home loan and will be diverting all to mf sips.
Me and my wife are working professionals and we have been investing for our goals for a couple of years.
Does this strategy sound good to you ?
I think every decision in life is not purely financial. As rightly mentioned, emotional aspect plays a huge role. After few years of paying EMI, especially in varying interest rate cycle, it is a huge relief to be debt free. It certainly has a positive impact on other aspects of life.
To each his own, I guess.
Hi Hemant
Taking personal loans to buy cars and other consumer goods by well to do people makes no sense to me.
I have been a regular visitor of your blog since four years. I must say that you have done a remarkable job in trying to pass on financial education in a simple and logical manner. I have followed most of your advices such as asset allocation, diversification, porfolio balancing, tracking expenses, loan management, SIP, excel spreadsheets and the list goes on. My clarity of thought in financial aspects owe a lot to this blog. Great work and hopefully your work reaches out to many more.
I agree, If someone have funds then he/she should first clear the loan and then think about investment.