Investing vs Loan Repayment – Which One to Prioritise?
At some point, everybody has gone through the dilemma of what to do with a large surplus fund. It is, of course, a smart decision to invest the money to grow your wealth over time. However, if you have existing debt, it may be wise to clear it first.
You must set priorities straight to get the most out of your capital. The priorities can be set based on age, financial status, and objective. For example, a younger person is more likely to opt for home loans, credit loans, and build emergency funds.
On the other hand, older people are likely to build retirement funds and earn a stable income, to enjoy a hassle-free life.
Things to Consider before Making a Decision
Let us discuss the factors to help you decide which financial decision can prove fruitful for you.
Rate of Interest
The interest rate at which you need to pay your debt and the interest you earn from your investments in debt securities help you determine your financial priority. For example, investing may be better if you earn more from your investments than you need to pay on loan.
However, if you have high-interest debt outstanding, like personal or credit card loans, you should prioritise paying off your liability first.
Let’s understand the same with an example. Suppose you borrowed a loan at an 8% interest rate annually. At the same time, you also invest an amount on a debt instrument like bonds which offers a 10% interest rate. Subsequently, in this case, you may want to invest rather than repay your loans.
Type of Loan
Certain debt types are better paid off in advance to avoid an accumulation of excess interests over a long tenure. In contrast, low-interest loans can prove beneficial for you over the long term, like a home loan. It can give you tax benefits too.
For example, if you choose not to sell your house within 5 years of possession, you can claim a deduction of up to ₹1.5 lakh per year for your principal repayments. Furthermore, you can avail a deduction of up to ₹2 lakh every year for interest repayment for houses constructed with borrowed money.
These deductions fall under the provisions listed under section 80C and section 24 (b) of the Income Tax Act of 1961. Therefore, you can save money every year through loan repayments if you have tax liabilities.
People with a stable source of income can easily decide what to do with some extra cash available. The advantage of having an established financial situation is that even if your choices do not go as per your expectations, your salary can compensate for the same.
However, people who are yet to attain a stable financial status or have a volatile job; need to allocate their funds carefully. Generally speaking, it is advisable to set aside money for investments and to have emergency reserves on hand. High-interest debts are an exception, as their interests would grow considerably if you do not repay them as soon as possible.
Volatility and Compatibility of Investments
Randomly investing in equities or futures offering generous returns may backfire, as these investments are for individuals with high-risk appetites and are volatile. Therefore, the returns offered are not promised and are subject to changes per the market scenario.
However, there are several investment options, like fixed deposits and bonds, which cater to investors with moderate to low-risk appetites. These avenues with fixed interest rates allow a conservative individual to decide whether to opt for investment or repay their pending loans.
When to Invest Your Funds First?
Although allocating your surplus funds to investments or to repay your outstanding loans are personal choices, you may consider the following points if you need strategic parameters to make the most out of your funds.
- Your investment returns are more than the debt cost.
- Your debts avail tax benefits or deductions more significantly than the costs.
- You have low-interest debt.
- You have long-term investment goals, like buying property and vehicles, saving capital for retirement, etc.
When to Repay Your Loans First?
The parameters below suggest an individual allocate funds to repay loans first.
- You have high-interest debt outstanding such as a personal loan or credit card outstanding.
- You have debts that do not avail you tax benefits or deductions.
- You want to increase your credit scores.
Whether you want to utilise your funds for investments or repaying loans, completely depends on your financial situation and goals. Investments and loans are completely different; while investments can help you grow your wealth, repaying your debt will improve your credit score and keep you stress-free.
Frequently Asked Questions (FAQs)
Can you borrow to invest in stocks?
If you are confident that your stock investments will yield higher returns than your debt cost, you can opt for the same. However, you should know this carries considerable risks as stock investments are sensitive to market volatility. It should also be considered that some lenders put conditions on the end usage.
What are some safest investments?
Some debt instruments which are safe or have low risks are fixed deposits, bonds, debt mutual funds, money market securities, etc.
How is loan repayment related to credit scores?
A credit score establishes a borrower’s credibility based on many financial parameters, including pending debts and repayment tenure. Paying loans timely can positively affect your credit score.