Should I pay off my loans or invest for future goals? Or should I simultaneously tackle both?
This and similar questions belong to a class of debate (Pay off Loans Vs. Invest), where to be honest, there is no one perfect right side to choose.
Readers of Stable Investor regularly send me questions on this topic and when I got another one yesterday, I thought maybe I should write something about this debate again. I have already written about it earlier here, but that was long time ago.
Before I share my thoughts, let me confess something upfront. I don’t like loans.
I am somehow unable to like the concept of borrowing, even though I completely understand that smart people can use leverage to make some serious money.
Generally, Indians are taught to avoid debt. That is how most of us have been brought up (exception – industrialists 😉 ).
And till few years back, many people looked down at the concept of borrowing.
But ofcourse things are changing. Slowly but steadily, we as a society are moving towards accepting the idea of preponing realization of our financial goals, with the help of loans. Very recently, a cousin of mine purchased his first real estate asset (a 3BHK flat) in a decent location in Bengaluru. Ofcourse it was with the help of a ‘big’ loan. And he is only 30 years old. Would this have been possible earlier (may be 15-20 years ago)? I don’t think so. So things have changed a lot indeed.
Now coming back to our discussion…
The question of whether to pay off the loan or invest is a very common dilemma. More so for people who have taken housing loans few years back. At that time, they took a loan, for which they could somehow manage to pay their EMIs. But with the increase in income during the next few years, they now have the ability to pay back more every month, if they want to.
Example – A person had an EMI of Rs 20,000 in the year 2011 when he was earning Rs 70,000 a month. Now after 5 years, his income has risen to Rs 1.2 lacs a month. So assuming (for simplicity) that his EMI is almost the same, he can comfortably choose to increase his EMIs. Isn’t it?
That is true.
But housing loans are way cheaper than other forms of loans and given the additional tax-benefits, there does seem to be a mathematical case of not repaying the loan early – as effective loan rate is reduced further.
The extra money can instead, be invested in products that are historically known to give average rates of return that easily beat effective loan rates. I am referring to long-term investments in equity mutual funds.
Ofcourse there is no guarantee here. But chances are pretty high that average returns (if you stay invested for long enough) will be pretty decent.
I think the above discussion is more general and its better if I get down to the specifics…
So lets consider a scenario.
What if you have a home loan but unfortunately, almost no savings whatsoever? Whatever you have in the name of saving, is also locked up in long lock-in products like PPF.
In such a case, it’s a no brainer. Forget about paying off your loan.
Irrespective of what mathematics and online prepayment of home loan calculators tell you about interest differentials, you should carry on the loan as it is and start saving some money first. As I said, don’t worry if returns from your savings are even lesser than effective home loan rates.
Just start keeping aside some money into a sort of emergency fund. And once you are out of the situation of zero-savings-lots-of loans, only then you should think about whether to start prepaying your loan, invest for future goals or even think about getting into the home loan vs. mutual fund debate.
But wait… why are we just focusing on home loans? There are many other kinds of loans too.
So what if you don’t have a home loan, but instead have a car loan, or a personal loan or some credit card debt?
When it comes to these types of loans, it’s better to take help of mathematics. The reason is that these are very costly forms of loans.
Credit cards – Costs more than 40% interest
Personal loans – Costs more than 15% interest
Auto loans – Costs around 15% interest
Now there is no easy way to invest your money where you can be assured of getting more than 15% returns every year.
Equity MFs have given better returns in some cases, but the returns are not stable. It can be +50% in one year and -20% in another. And you don’t want to be caught on the wrong side here. Average returns are better but as I said earlier, there is more to just quoting average return that meets the eye.
So, if you have credit card debt or a personal loan, repay them first. Clear them off as soon as you can.
Note – The earlier stance on having some savings as emergency fund still stands. That’s a non-negotiable.
The need is to prioritize your loans according to interest rates and clear them off.
I have seen people paying minimum dues on Credit Card, which means they are paying 40% interest on their credit card outstandings and still investing in stock markets.
That is outright foolish unless they can prove that they will earn better returns from markets than they are paying on credit card dues. 🙂
Here, I would like to return to the emergency fund discussion again. Whether you repay your loan or you invest for future – should depend primarily on how exactly is your emergency cash situation.
Do you have a stable job and have the money to take care of short-term expenses (both expected and unexpected)? Think about it.
Another point to note is that when we choose to invest instead of repaying the loan, you are betting on the fact that your investments will necessarily do good. That’s easier said than done my friend. There are so many things that can go against you. Wrong choice of fund/stocks, markets going into a free fall, etc.
I am not saying its wrong to invest, when you have a home loan running. I am just saying that you need to be aware of the risks you are taking.
I am sure many of you would be thinking that I have still not said a word about the emotional and psychological aspect of clearing off loans. 🙂
So here it is…
Is prepayment of home loan beneficial?
The answer depends on the chosen aspect – mathematical, emotional or psychological.
But yes, it’s a great feeling to have Zero loans – no doubt.
And it allows you to sleep well too. 🙂
No amount of maths can capture this benefit in any form. So if you like me are debt-averse and prefer peace of mind to interest arbitrage, then you should pay off your loans. Don’t worry about what others are thinking about you.
You have the right to extract most units of happiness from your money. 🙂
Paying off loan also makes sense when you think about the risk of job loss. So your (and your spouse’s) job stability should also be a factor when you are thinking about prepaying or not prepaying your loans…
…as defaulting is not an option – unless you are the now-supposedly in London – King of Good Times. 😉
If you are targeting early retirement, then once again it makes sense to close out your loans quickly. But if you intend to retire at a normal pace (around 60), then investing for your retirement should also get a very high priority – somewhat similar to that given to servicing of loans.
It has already become a very long post now. My apologies.
So let me quickly list down a few points that will help you keep track of the above discussion.
Whenever you have enough surplus money to ask yourself the question – whether to pay off loan or to invest, think on these lines (in the given order):
- Your first priority should be to have a big enough emergency fund in place – which can take care of any unforeseen money requirements
- Identify all loans with very high-interest rate (like credit cards)
- Get rid of them as soon as possible.
- Identify other high-interest loans like personal loan, car loans, etc.
- Also, identify low-cost loans (especially home loans).
- Under most circumstances, you can continue to invest and simultaneously pay off low-cost loans.
- As for the high-interest loans (personal and car loans), it depends on how much is the available surplus and what are the effective rates of interest. Mathematically, it might make sense to pay off these loans first, but you can take your own call.
On a personal note, if I have a personal loan that I am able to service comfortably + I also have some surplus money every month + there is big market crash where there are clear indicators that investing would make sense for long term, I will go out and invest my surplus in markets instead of paying off loan. Sounds risky, but that is for me. 🙂
But in case I have credit card debt (very high rates) in the above situation, I will make sure to clear it off first before investing in markets.
So as you can see, this question has no one right answer.
You can use some pay off your loan or invest calculator and come up with a mathematical (theoretical) answer. But in reality, it depends on many other factors like borrower’s exact financial situation, risk capacity, risk preference (appetite) and available alternative opportunities.
You are the best judge of whether you should pay off loans, save or invest or balance the two. Give it some serious thought if you are in that situation.
Good one… Even though everyone is aware of this, it gives an opportunity to introspect yourself… Thanks
Thanks Vijay 🙂
I have the same questions in my head. Thanks for sharing this article.
Thanks Chris 🙂
Hi Dev, your articles are helping me a lot! Reading them for just one month. Could know about this blog from Safal Niveshak……..thanks a lot for helping the ignored masses…
Thanks for your kind words Vineet 🙂
Thought Provoking and forcing oneself to take action immediately…So far one of the best article on the subject read by me…Thanks
Thanks Kamal 🙂
Very Good Article!