If you get some additional money in hand via a bonus or a pay raise – what should you do? Indulge yourself, pay off your debts/ loans, if any or invest? There are seldom any easy choices there – especially when it comes to paying off debt versus investing. And both may have their own merits and demerits!
In this article I’ll share some of my thoughts on how can you prioritize paying off debt versus investing money and different factors you can consider while making this choice.
(This assumes Indian context but can be applicable elsewhere too!)
What are different types of debt you can possibly take?
Home Loan – Typically this is a large ticket loan for most of the people. And prepaying it may not be everyone’s cup of tea. Rate of interest on home loan in India starts at around 8.5% per annum (this varies a bit based upon policy changes). Home loan repayment offers tax benefits too – for both principal as well as interest repayment. People usually take home loan for
Other debt – Car loan, personal loan, Consumer loans, gold loan, credit card dues etc. – These loans are typically at a higher interest rate than home loan. Currently, interest rate on car loan starts at around 9% per annum. Personal loans typically start at around 10% per annum, but can be much higher. Interest on credit card can be much higher.
For individuals, these don’t offer any tax benefit (Except personal loan for buying home – partly)
(All these rates are at current interest rates. This can vary a big based upon government policies)
What are the rate of returns you can earn on your investments?
I’ll classify these into two broad categories – Investments which give more or less assured rate of returns (however, be aware of risks also!) & investments where returns can a lot!
Category 1 – Investments which can give almost fixed rate of returns
- Fixed deposits in most of the major banks in India currently give 7-7.5% per annum rate of interest (It can be higher for some smaller banks).
- Some corporate deposits can give a bit higher – even around 8-9% per annum (but there is a risk of default. This risk is usually less in case of reputed companies, but it is nevertheless there)
- PPF currently gives 8% per annum and PF gives 8.65% per annum (including voluntary PF – VPF). You an read about other tax saving investment options here (typically they give higher rate of returns.)
- Liquid funds can be expected to give rate of returns similar to fixed deposits. Debt funds can give slightly higher rate of returns (but there is a small risk too!). They are not same as fixed deposits, but returns generally don’t vary much.
Category 2- Returns are neither fixed nor assured
- Equities and equity oriented mutual funds – This is a a bit tricky. Equities over a long period of time has given good returns, not just in India but most of the markets. In India, it has been > 10% for most of the times in recent history, over a on run. But you usually can’t predict returns in equities. While most of us expect the returns to be good, there is no surety.
- Real estate – Here too returns can either be very good, or stagnant or even negative. Lot of local variables come into play here, so it is difficult to give blanket opinion on it. In addition, one needs to be aware of the real cost of buying a real estate for investment, if you are looking at it as an investment which can generate profits.
- Gold/ silver – It is also a popular investment especially among Indians. While its prices have been stagnant off late, it may or may not give much returns in future.
Paying off your debt- What are the pros?
- With loans come the interest which you pay month on month. You eventually pay much more than the loan amount due to that interest. By paying it off, you are getting rid of that burden.
- Investing money may or may not give better returns than interest you are paying.
- Being debt free may lead to lesser stress & better peace of mind!
Paying off your debt – What are the cons?
- Your investments may actually give better returns! (but difficult to predict!)
- You may lose out on tax benefit (e.g. in home loan – both principal & interest repayment)
- Some loans may have prepayment penalty. Be aware of them.
My take on paying off debt versus investing money?
Assuming you have multiple debts/ loans, here is my suggestion on how you can proceed:
- Pay off the debt with highest interest rates first. (This is different from Dave Ramsey‘s school of thoughts which suggests to pay smallest loans first!). Keep paying regular EMIs on all loans, but do pre-payments/ loan closure on high interest rate debt first.
- Pay all your debts till you are left with only home loan. (Assuming that is is the one with lowest interest rate)
- While paying off the home loan, you can start investing towards your financial goals also. Evaluate the tax benefits you are getting on home loan principal repayment and interest repayment. If there is sizable tax benefit, you can avoid rushing for prepayment. But if this tax benefit is little, you can try to pre-pay and close it! (If I have a choice, I will look to close it!)
Actual answer can depend upon your calculations and your financial status. Like in personal finance, this is both personal as well as financial. So, you need to do your own math and arrive at an answer.
Being debt-free is the first step towards financial independence, if that is your goal. In this case is also becomes important that once you have cleared off your debt, avoid further debt altogether!