The Dilemma of Repayment or Investment

Do you like being in debt? We don’t. And we think no one does.

Even as a country, we have till recently abhorred taking on debt. We are a country of ‘savers’. And if there was a sport in the Olympics where countries competed on the basis of their saving rates, we would have got gold (finally!).

But in spite of saving so much (as a country), we do need to take the help of loans every now and then. Take a home loan for example. Can we possibly buy a house without a loan these days? Almost impossible.

Take an education loan for example. An MBA from good college costs upwards of Rs 15 lacs. Can you bring that amount from your own sources or from your parents? Very difficult again.

As you see, sometimes taking a loan is the only option. But the story never ends there. All of us want to pay off our loans as quickly as possible and there is always this dilemma.

"Should I prioritize loan repayment (and repay faster) or instead use surplus savings to make fresh investments?"

Whether to prepay the loans or not, depends on the type of loan in question. For most people, the loans are of the following variety:

• Home loan – about 10% (lower if you consider tax benefits)
• Car loan – 10% to 15%
• Personal Loan – more than 15%
• Credit Cards – about 40% (yes! Didn’t you know that?)
• Loan from family/friends – 0% (lucky you!)

As you can see all loans are not equal. Credit card debt is the evilest. Some others are cheaper (when we include tax benefits) and also help us build assets (like a house).

Which Loans to pre-pay first?

Mathematics tells us that we should repay the highest interest loans first. To do that, first of all, you need to make a list of all outstanding loans and identify the ones that are most expensive, ala, the highest interest rate.

Since credit card (40%) and Personal Loans (15%) are the costliest ones, ideally you should start by repaying these first and in that order.

But don't go over-board and ignore any other loan EMIs. Without jeopardizing payment of regular EMIs for ‘all’ loans, start using your surplus cash / monthly savings for credit card and personal loans.

Should you use your existing savings to pay off these expensive loans?

Now, if you have an FD earning 6% (after-tax) and a credit card outstanding charging you more than 40%, then it makes sense to liquidate the FD to prepay the loan. But for low-cost loans, dipping into long term investments like PF, mutual funds, etc. is not advisable as it breaks the process of compounding.

Note – Some loans have tax benefits. Like the interest paid on education, the loan is tax-deductible. Also, interest and principal of housing loans are tax-deductible (to an extent under different sections of income-tax calculations).

Forget about pre-paying if you have no Investments

If you have loans but no savings or investments at all, then you should simply forget about prepaying your loans.

First of all, start putting aside some money in an emergency fund. Irrespective of the high-interest rates that your loans have, start building a small pool of saving before you start prepaying your high-interest loans.

If your loans keep you awake at night, here is a quick guide to get debt-free

• Identify all high-interest loans (credit cards, personal loans)
• Start clearing them off starting with highest interest loan
• Keep paying regular EMIs for all loans
• After paying off expensive loans, divert surplus to create Emergency Fund
• Identify low-cost loans (home loans, education loans)
• Start investing (in instruments like mutual funds) simultaneously as you service EMIs for the low-cost loans
• If income increases (or you have a windfall like an annual bonus), push apart into investments and other into repaying low-cost loans

Should you continue Investing as you repay Loans?

Credit Card and Personal Loans are Evil. So before you invest surplus funds elsewhere, get rid of these loans first.

Now Housing Loan and Education Loans are still ok and you may keep them as you invest elsewhere.

But putting aside all your investible surplus in FDs which give 6% post-tax returns doesn’t make sense. After all, loans even after-tax benefits will not cost you less than 8%.

So at least a part of the surplus should be invested in products that have historically given returns that are more than effective loan rates, like equity mutual funds.