Hello fellow investors
Every person who takes a loan faces the question of whether they should prepay the loan or invest the surplus.
You take a loan at an EMI you can afford. Eventually, your income increases and you find that can pay back more of the loan than you had originally planned. So what should you do? Prepay your loan or invest the surplus?
The answer to this question depends upon 2 things:
A. How much interest are you paying on your outstanding loan?
B. How many returns would you earn by investing that money?
If the trade-off is positive enough then you continue with your loan and invest and if not – you prepay your loan. Pretty simple right? I shall break this up for you based on the type of loan you have and what kind of investments you are comfortable to make.
Credit Cards & Personal Loans:
These are the most expensive loans ever! In fact, the cost of borrowing i.e. the interest you pay on your credit card varies from 2% - 4% per month i.e. 24% to 48% per annum. The interest on your personal loans is also usually 14% - 18% which is also pretty high.
The only way you can earn a return higher than these loans is by taking an extreme risk with your investments which include the risk of losing your capital. It makes no financial sense in not paying your card bills and using that money to make investment gains.
Given choice, prepay your credit card and personal loans with your extra savings.
Education Loans and Home Loans:
Education loans are attractive for their tax deductions. Home loans are the cheapest and the longest loan that you will ever own and hence, there is always a question of whether to prepay your home loan or not.
To help you decide, you should do the below three checks.
One way to check this is how comfortable you are with your home loan. If the home loan EMI is at 50% of your take-home income – you should consider pre-paying your Home loan and reducing the EMI to at least 20%-30% of your take-home income. If it is already a 20%-30% of your home loan EMI, you can consider continuing with the home loan.
Next, you need to consider the returns of your current investment opportunities i.e. what is the after-tax return of available investments opportunities versus the interest burden on your home loan.
Let us understand this with numbers:
Cost of home loan: Home loans EMI are at an interest cost of about 8.00% per annum. If you fall under the 20% tax bracket, the home loan cost is reduced to 6.40% after assuming you are able to claim the entire interest as a deduction in your Income Tax Return. If you come under the 30% tax bracket, the cost of your loan falls to 5.60% because of the tax-saving you get.
Return on Investments: It will make sense not to prepay the loan if the returns you will earn from investing today are higher than your cost of 6.40% or 5.60%,
How much you earn from your investments would depend upon in which asset class, you invest your savings:
1) Fixed deposits – The interest rate on Fixed Deposits today range from 5.00% to 6.00%. Some of the Corporate deposits are yielding returns in the range of 7%. The post-tax returns will be lower by 20%/30% depending on your tax bracket.
If you are risk-averse and generally park your money in fixed deposits and other safe and low-return instruments, then you are certainly better off using your surplus earnings to reduce the home loan.
2) Equities - The returns on equity investment average about 12-15% over 10-15 years. So investing your surplus into Equities is numerically more beneficial than prepaying the loan.
But before you make the decision to invest the surplus in Equity Mutual Funds/Equity Stocks, you must check if you have the risk tolerance for dealing with the ups and downs of the equity market. You should choose to if you are planning to stay invested for 7-10 years because equity investments give better risk-adjusted returns over the long term only.
Also, by investing the surplus into Equities, your target Debt Equity ratio determined by your Asset Allocation should not get skewed towards Equities.
In conclusion, the decision to prepay the loan or not depends on your existing financial situation, the extra earnings from investments, and your risk-taking capacity as an individual.
Do ensure that you have your emergency fund in place and some investments at your disposal before you go ahead and prepay the loan with all the money at hand.
See you next Thursday!
Disclaimer: - The articles are for information purposes only. Information presented is general information that does not take into account your individual circumstances, financial situation, or needs, nor does it present a personalized recommendation to you. You must consult a financial advisor who understands your specific circumstances and situation before taking an investment decision.