16/10/2018
Is waiting to clear off loans before investing correct?
Conventional wisdom (arguably) says that it is better to pay off the loans first. Being loan-free gives mental peace, which of course cannot be doubted.
Should you pay off the loans before starting to invest for your financial goals? Or you should do it in tandem?
This is a common dilemma that many borrowers have.
Conventional wisdom (arguably) says it is better to pay off the loans first. Being loan-free gives mental peace, which of course cannot be doubted.
But this sort of mental peace means that you would not be investing for several years (at times up to 10-15 years).
Does this make sense?
The answer is No - as you will miss out on a lot of compounding which otherwise would have created a big investment corpus.
When it comes to income, both loans and financial goals have a claim on it. Unfortunately for common people, the loans have to be paid back (at least as per schedule if not earlier). On the other hand, financial goals are what money is really needed for. Ignore them for too long and slowly but surely, you will become unprepared for the future. And that is dangerous. So ideally, there has to be a balance between the two.
Before you decide to repay the loan or invest for the future, you should assess how is your emergency preparedness, i.e. emergency fund situation.
It doesn’t have to be a huge one. But have at least three or better still six month’s expenses worth of funds parked in it. If you don’t have some savings earmarked for emergencies, then I seriously suggest you forget about loan prepayment and investing. Save some money first for emergencies.
With that aside, let’s move on to the question of paying off loans vs investing. The theoretical answer depends broadly on 2 factors:
After-tax rate of interest being paid on the loan
The expected after-tax rate of return on investments
If you have several loans, first and foremost you must list them down - write down the outstanding amount, interest rate, tenure and tax deductions (if any).
Typical personal loans cost around 15 percent. Car loans around 11-13 percent. And I hope you know that credit cards cost about 30-40 percent.
If you have any of these loans and are contemplating investing instead of closing these loans, then you need to find investment options that can pay you at least 13-15 percent plus annually. Unfortunately, there are no easy ways to invest where you are assured of such returns every year. Equity can give better returns in certain cases. But equity returns fluctuate and aren’t guaranteed. So you don’t want to be caught on the wrong side of equity returns.
Best thing to do if you have credit card debt or a personal loan is to repay them first. Clear them off as soon as you can.
But what about the biggest loan of them all - the home loan?
Home loan is one of the cheapest loans available. And if you consider tax benefits, the effective loan rate reduces further. Then there is the possibility of generating rental income and the potential for capital appreciation - which makes the home loan a good one to carry.
For low-cost loans with tax benefits (like home loans), the focus should be more on meeting repayment obligations rather than on closing them fast.
There is even a mathematical case for not opting for a short loan tenor (and higher EMIs) and instead opt for longer tenor (and lower EMIs), and use the differential EMI amount to invest regularly in equity funds via SIP. In some cases (of good returns), it can help pre-close the loan earlier than what would have been possible using higher EMIs!
Of course, there is a non-zero chance of not getting good returns on the investments. But there is also a high probability that the average returns will be pretty decent and more than effective home loan rates.
But choosing to invest instead of prepaying home loan cannot be an ideal choice for everyone. It depends on individual circumstances, risk appetite and hence should be dealt with differently.
So what should you do?
Ensure first that you have a reasonable emergency fund (about 6 month’s expenses worth)
Ensure life and health insurance premiums are paid
If you have money left, first clear off any credit card outstanding
Then begin clearing your personal loan
Keep paying your home loan EMIs regularly
[Optional] Try to put aside 2-3 month’s EMI for cash crunches
Begin saving for important goals like retirement, children’s education, etc.
After that, it’s your decision whether to increase your home loan EMI to slowly prepay it (conservative approach) or to invest regularly in equity funds to prepay in one shot later (aggressive approach)
Consider making additional ad-hoc payments to home loan - like by paying one extra EMI every year, using the part/full annual bonus to prepay, etc.
Remember, it's better to make prepayments in the early years of the loan when principal outstanding is high.
After reading all this, if you still prioritise living a loan-free life, then go ahead and simply pay off all your loans (need for emergency fund still remains). But just remember that as your income increases, you should simultaneously increase the allocation to investments sharply to catch up on the lost time when you were going full-force with loan elimination.
