Extra cash? Which utopian world has concepts like these? Well, that’s what I thought a few years ago. However, if you maintain your financial discipline, you will encounter a situation where you may not have done a future expenditure using your credit cards. So, the moment that bank message of credit hits you in the month you are supposed to get bonus, what should be the next steps? Should you pay off debts or invest?
The Debt vs Investment Conundrum:
Recently, I was in one such dilemma. I got a bonus from work in the end of FY20. I had a pending car loan at that time. So the big question in front of me was if to repay the loan? or invest the lumpsum amount somewhere. And like most of us would think, I also thought that loan is at some 9% rate of interest and I can fetch some 13%-14% by investing in equity of MFs. So it’ll make sense that I invest and repay the loan at it’s pace.
With that thought in mind, I laid down a diversification plan for the lumpsum money I was about to get. But, one fine day, I discussed this with one of my acquaintance. And what he said is going to shake the foundation of the logic we just mentioned.
He mentioned that if the above holds true, everyone would take a loan and invest it in equity market. And later pay off debt and earn 4% profit. And even if I didn’t understand this at that very moment, one thing was sure, that my strategy needed some revisiting and revision.
So, I decided to research on the topic, should you pay off debts or invest? Not specific to car loan, but in general if one has some cash in hand, what possibly could be the approach? Sharing my findings with you:
Disclaimer: Personal finance is highly customized. This is by no means a financial advice. Please consult your financial advisor.
A quick warning before we start: A lot of approximations ahead. This will simplify the calculations and give us the general idea. By no means it will hamper the end result of this discussion.
Let us think of all the investment options in hand along with their returns.
|Instrument||Average Return||Tax Adjusted Returns||Remarks|
|FD/RD||6%||5%||(-)Capital Gains Tax|
|Insurance||6%||5%||(-)Capital Gains Tax|
|Real Estate||8%||7%||(+)Assuming Rental Yield @3%|
(+)Capital Appreciation @5%
(-)Capital Gains Tax @1%
|Gold||8%||7%||(-)Capital Gains Tax|
|Mutual Funds/Tax||13%||12%||(-) Capital Gains Tax after gains of Rs. 100k|
So, I have listed all the conventional investment options starting from lowest returns to highest. Let us explore our loan types is well in a similar fashion.
|Credit Type||Average Interest||Tax Adjusted Interest||Remarks|
|Home Loan||8%||7%||(+)Tax Benefits in 80C and Section 24|
|Credit Card Loan||36%||36%||NA|
So the above table lists the most popular types of debts one has along with the interest rates they charge.
Moment of Truth:
So now we know all this information, what are the next steps? It is quite easy to formulate some thumb rules from here. Let us discuss about them in detail:
- The cheapest form of debt is a home loan. As cheapest instrument comes at a cost of 7%, it is fair to assume that your extra cash just cannot go to the investments that are fetching interest rates less than 7%. So you can rule out FD Insurance, PPF/EPF/NPS/SSY and gold here.
- Even if you don’t have a home loan, you should never park your spare cash in either of the above instruments if you have any sort of debt.
- Secondly, it is quite evident that no matter what, if you have a credit card loan in your portfolio, you need to get rid of it on the topmost priority. None of the investments will fetch you returns of ~36%, at least in short term. If you have any such investment in mind, please let me know in the comment section below so that I can invest there as well.
- On a similar note, you should prefer to get rid of personal loans (if applicable)
Home Loans/Car Loans Vs Stocks/Mutual Funds?
Mutual funds be like: Finally a worthy opponent.
Now Mutual funds can fetch you a larger return than the interest than home loans and car loans. So should you not pay off your loans and rather invest in this case? The answer beholds the beauty of the personal finance. Just like it’s name, it is highly personal and customized. However, a set of rules that would help you take a decision are covered below:
Remember that 3x sped up voiceover in all mutual funds adverts? I would quote that for you:
“Mutual Fund Investments are subject to Market Risks, please read the offer documents carefully before investing.”
So, neither of us can say with a 100% conviction that our mutual funds/stocks are going to outperform our home/car loan rates. While you usually make a profit in MFs for a longer horizon, there are individual years in that horizon that may be giving you a negative return. Your master plan of beating interest rates and gain profits may take a hit at that time.
In such a scenario, I would usually gauge the market condition. If it is already near it’s top and is booming, I would prefer to put the spare cash in loan account rather than stock markets. Similarly, in case market is in bear mode, investing in stocks may boost my chance of beating the interest rates. As an example, if I had to make this choice in March and April, I would have invested in stocks, however in the current scenario, repaying loan seems a better option to me.
Amortization schedule is a table that consists the values of period EMIs towards the loan account along with the break up of that amount in towards principal and interest. Generally, as the loan nears it’s closure, the amount going towards interest keeps on decreasing. This mean that your early payments cover what is owed towards interest and later, more is contributed towards principal.
This can be a key metric to decide weather or not to put that extra cash for loan repayment. For example, if you are only 1 year away from your loan closure and have to pay 2L (say) for the same. Most of that 2L is going towards the principal repayment. In that case your rate of interest is very low (because there is negligible interest). So, that means, you should ideally invest that money rather than putting it towards clearing off debt.
Now that we have compared all the possible investment opportunities and debt variants, it is clear that real problem statement narrows down from “Should You Pay off Debts or Invest” TO “should you invest in equity or pay off your debts”.
Please note that if you pick the options to invest in equity, make sure you do a thorough research and pick up your options wisely.
I took care of this situation by investing in some blue chip stocks at that time. Market was recovering from it’s March lows and those stocks have given me a return of almost 50% in these 9 months. While this is an unusual scenario and may set unreal expectations, but the fundamental underlying principle of investing in equity at lows worked out for me.
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Until next time..
Until Next time..