Pay Off Loans or Start Saving & Investing?

Payoff loan or Invest Save
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 cardsCosts more than 40% interest
Personal loansCosts more than 15% interest
Auto loansCosts 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):
  1. Your first priority should be to have a big enough emergency fund in place – which can take care of any unforeseen money requirements
  2. Identify all loans with very high-interest rate (like credit cards)
  3. Get rid of them as soon as possible.
  4. Identify other high-interest loans like personal loan, car loans, etc.
  5. Also, identify low-cost loans (especially home loans).
  6. Under most circumstances, you can continue to invest and simultaneously pay off low-cost loans.
  7. 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.

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What I told a Frustrated Guy in Job. At 37, He Retired few Months Back – Part 3

This post was long due after I did Part 1 and 2 in April this year. Though the story of this guy was covered in first two parts, I wanted to do a follow up post highlighting some of the important points raised in comments of the post.

Readers like Krish, Bharat and many others made some noteworthy points, which I feel need to be shared with a larger audience and hence this post.

You can either read the complete story in detail in Parts 1and 2;Or just go through the broad outlines below:

This person had a big home loan, was earning decently, but just sufficient to make ends meet (after paying his monthly loan EMIs), had very little savings and investments and more importantly, was frustrated with his job and financial situation.

Luckily, he inherited a plot of land which till a few months back, he did not know what to do with. 

What he does afterwards, is what changes his life:

Step 1: Sold off the land plot for Rs 9 Crores (post tax).

Step 2: Closed his home loan of Rs 70 Lacs.

Step 3: Created an Emergency Fund of Rs 30 Lacs (which covered his family’s expenses for next 2 years).

Step 4: Put Rs 4 Crores in Fixed Deposits, which provide approximately Rs 1.75 Lacs every month in interests (post tax).

Step 5: Bought 7 flats for Rs 3 Crores

Step 6: Bought a small warehouse (godown) for Rs 1.1 Crore

Step 7: Put 5 (now 6) of these flats on rent for a total of Rs 1 Lac a month.

Step 8: Put Godown on rent of Rs 60,000 a month.

Step 9: Quit his day job

Note – Actually he quit his job before the godown went on rent.

To summarize, he used proceeds of selling his inheritance to create a monthly income stream of more than Rs 3 Lacs. His average monthly expenses are between Rs 50K to 60K.



Now this is the current situation. And we do not know what might happen in future.

But few readers raised concerns about this approach and shared some different approaches. I share their concerns and ideas below:

Point 1: Cashflow is great in terms of interests, rents etc., but over the years expenses also rise. Not only because of inflation, but also because of altogether new expenses like kid’s education, medical bills, renovations, etc.

Point 2: If investment in properties (flats) is made for capital appreciation, then one should understand that it is not that easy to sell off properties. Banks are generally skeptical about lending to buyers for older properties.

Point 3: Once again if investment in property is made for capital appreciation, it makes sense to buy in relatively undeveloped areas. Then wait for 3-5 years and sell them off. In this way, one can cash out on overall upgradation (read: development) of that area, and the increase in desirability quotient of that area. If one waits for more than 5-7 years, there’ll always be a problem of “Old Flat” perception.

Point 4: In rental properties, each time a tenant vacates, it requires big expenses in form of painting, cleaning, plumbing, unsolicited breakdown of utilities, etc to get the flat ready for next occupant. This eventually reduces the actual rental income coming from the property.

Point 5: Dependency on rental income often proves to be fickle and it does not even beat inflation. Since chances of real estate markets being in bubble currently are high, expectations of very high capital appreciation would be wrong.

Point 6: There is an increase in people seeking help / donations / loans when they realize that you are flush with funds and living off without working for anybody else.

Point 7: With so much money coming in every month, life style changes and expenses on luxuries like foreign trips, electronic gadgets tend to increase. These eventually reduce the surplus every month.

Point 8: Could have chosen not to close the home loan and continue getting tax benefits. The money could have been used to earn hefty interest.

Point 9: Plan of taking another loan (>2 Crores) and use the monthly surplus to pay EMIs can be a big risk as it greatly reduces the free cash available every month.

Point 10: Plan of starting a money lending business is a big no-no if one gives any weightage to peace of mind.

Point 11: All the proceeds from sale of property could have been put in debt funds (50% Growth, 50% Quarterly payout). After decent quarterly payout accumulation, the money could have been invested in Equity Mutual Funds and Residential plots in small towns as in long term, only MFs, Direct stocks and Land are game changing wealth creators.

Point 12: This person should not have quit his day job until his planned business had kick started. Any business started after inheritance is more of a time-pass and chances of it succeeding are pretty low.

These are few of the major points which came out of the discussion which took place in comments of the post. I personally do not subscribe to quite a few like not paying off loan (I love being debt free). But I also think that few of points like expenses related to properties are quite valid.

Overall, I think the approach taken has been quite prudent, driven by common sense and most importantly focused on generating cashflows. But finally, only time will tell whether its correct or not.

Life @ 13.99%

Many people take loans for various reasons. Some take it  for unavoidable reasons and others for avoidable ones…or for ones which can be easily delayed, like vacations, purchase of electronics, luxury watches, etc.

But before you read further, I would request you to understand that I am not against those who take loans. Everyone’s needs and situations are different. Even I have taken loans in past.

Since last few days, the following image is popping up on the website of a large private bank whose services I use to conduct my financial transactions.
Personal Loan - Vacation
As you can see, the bank is telling you few important things…

First is that ‘Life is waiting’. And that is a fact. Nobody can be wrong by making such a statement. There are so many things to do in life that sometimes I feel one life isn’t enough to fully experience life. 🙂

Now second thing to observe is that the image above shows a couple enjoying vacation in Europe (probably). Now a decent European vacation for two costs around Rs 4 Lacs. This picture pops up just before one logs into bank’s website. Therefore, my assumption is that bank is showing this image to everyone irrespective of whether person logging into bank’s website is or isn’t a suitable candidate to pitch such visual advertising to sell loans for luxurious expenditures. 

It means that bank does not take into account customer’s past average balance, repayment histories before making the (very first) pitch for the personal loan.

Once again, I am not saying that one should not take loans. But vacation is something which can be delayed. Or should be planned well for. Vacations are generally not spur-of-the-moment decisions.

So it is better to plan for them from the very day the final decision is taken. Isn’t it? And some people actually don’t want to take loans for such discretionary spendings. They plan well and well before the day funds are actually required. Just sometime back, I received a mail from a reader to help him plan his funding of a trip to Dubai he wanted to gift to his wife.

For the time being, lets not judge whether what bank is doing is correct or not. Bank can anyways justify its marketing actions by saying that there are proper processes in place for approving loans to check suitability of candidate.

And they are right in saying this. They can also give an example that there are no checks on who sees the hoardings on sides of highways offering home loans for budget(!) homes costing 1+Crore. Once again they are not wrong.

This brings us to a possible conclusion that onus and responsibility of applying for loans of any kind lies with customer and not with bank. 

Bank only evaluates suitability of the applicant and then decides to lend or not to lend to him / her. Bank is there to lend you money for all your expenses. But it is for you to decide whether you need to take a loan for something which is as discretionary as a vacation, or something which has the potential to generate future wealth like property or commercial vehicles. 

Always have limits to how much you will borrow and for what reasons you are willing to borrow. Because eventually, this will be a major determinant of whether you will be rich or not.

By the way, I feel that banks are generally ready to give loans to those who don’t need it. What do you think? Also, if you have any stories about your loan related experiences which you think will be beneficial for others, please feel free to share the same in comments or drop me a mail at stableinvestor@gmail.com

What I told a frustrated guy in job. At 37, he retired last month – Part 2

Before I continue from where I left in part 1, I will briefly summarize what happened earlier for benefit of new readers…

A few years back, I met a guy who was frustrated with his job and life. He had a big home loan, was earning decently, but just sufficient to make his ends meet every month. Surprisingly, he had a plot of land worth several crores which he till that date, had failed to utilize productively. 

In part 1 of this post, I suggested following 5-point action plan to him:

  1. Sell the land & use the money as described in steps 2 to 5.
  2. Pay off the home loan
  3. Create an emergency fund
  4. Set aside money in fixed deposit which would provide monthly interest income equivalent to his monthly salary.
  5. Buy flats and rent them out to create additional streams of income.

Now let’s continue with what happened next…

This guy gave me a call last Sunday and told that he had actually thought a lot about what I told him two years back. He then discussed the approach with his parents and other family members before taking a final call 6 months back.

What he did then is summarized below:

  1. Six months back, he sold off the plot of land for Rs 9 Crores (post tax).
  2. Almost instantly, he paid off and closed his home loan of Rs 70 Lacs.
  3. Parallely, he created an emergency fund of 30 Lacs to cover his family’s expenses for next 24 months.
  4. Five months back, he parked Rs 4 Crores in Fixed deposits, which now provides him with a post tax monthly interest income of more than Rs 1.75 Lacs (Much more than what he drew as his last salary).
  5. In next two months, he bought 7 flats worth Rs 3 Crores and managed to put 5 of them up for rent. Rental income from these 5 flats is more than Rs 80,000 per month. He is still waiting to put remaining two flats on rent.
  6. Just two months back, he bought a small warehouse (godown) for Rs 1.1 Crore. As of now, he is pretty close to cracking a deal with a logistics provider for renting out the property. Probable rental income from this property is expected to be around Rs 75,000 every month.
  7. With home loan paid off, and earning in excess of Rs 3.2 Lacs a month without going to office for somebody else, this person quit his job (read retired) after celebrating his 37th birthday last month.

How to use your inheritance
A brilliant example of how to use your inheritance

Astonishing…isn’t it? How life can change with one simple decision. 

A reader commented in part 1 of this post that this guy was simply lucky to have inherited such a plot of land. 

I am not sure whether its right to give all credit for this guy’s success to luck. Agreed that you need to be lucky to inherit something like that. But I assure you, mentally and emotionally, it’s not an easy decision to sell inherited properties. It’s a tough call to make. It may seem simple up front. But it is quite a difficult decision to sleep with. Anyways, we are not trying to judge anyone or anyone’s luck here.

The fact is that this guy does not need to work again for anybody else.

And for emphasis, I repeat.

This guy does not need to work again for anybody else.

And just to give you all an idea of how a person’s decision making changes when passive income starts flowing in….this person told me something, which will further astonish you.

He is currently earning Rs 3.3 Lacs from his investments. With renting of two additional flats, he might start earning close to Rs 3.7 Lacs. He told me that frankly speaking, he did not need more than Rs 50,000 every month for his normal expenditures. This left him with Rs 3.2 Lacs surplus every month. He himself suggested that he was thinking of choosing between the following 3 options to park his surplus funds:

  1. Take property loans (approx Rs 2.5 Crores) which would use up this Rs 3.2 Lacs in EMI. The property in turn could again be rented out to generate more cash.
  2. Put money in stock markets using SIPs in good mutual funds and direct equity investments.
  3. Start a small money lending business.

For the time being, it’s irrelevant what I suggested him and what he eventually chooses to do. But this tells how a person starts thinking of ways of making money once he is out of the mad rat race of getting salary every month. The decision making and thought process changes completely.

We talk about value unlocking in properties held by companies. And here we have an exceptional example of how normal people like you and me can unlock value from existing properties. Once unlocked, the money needs to be managed as prudently as possible. And with systematic approach like the one taken by this person, its now money which is creating more money.

By the way, he is not frustrated any more. 🙂

What are your thoughts on this?

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What I told a frustrated guy in job. At 37, he retired last month – Part 1

Isn’t this like a dream come true for all of us? Atleast for those of who are not working for themselves but for somebody else?

This post is about a person, with whom I had a casual chat over lunch some two years back. At that time, I (in my wildest dreams) could not have imagined that this talk would have such a big effect on his life.

But as it has been rightly said in Alchemist,

“When you want something, all the universe conspires in helping you to achieve it”

…in hindsight, it now seems that our little chat was the catalyst for something big which was about to happen in that person’s life.

He called up last Sunday to thank me for the little chat I had with him two years back.

At first, I did not realize what he was thanking me about. But when he told me everything, it was like a jaw dropping moment for me.

I will share this story in two parts…

And the first part of the story goes like this…

While doing my MBA internship in an organization, I came across a guy who looked quite old for his age and was a quite frustrated with his life. One day while having lunch together, he became aware of my interest in stocks and wealth creation in general.

And this got him started. He then told me quite a lot about his personal and financial life.

Frustrated Man At Job
 

He had been working in that organization for last 15 years. He was frustrated because though he was earning well, he was still barely breaking even every month end. He stayed in a decent 2BHK flat in New Delhi, which he had purchased 2 years back using home loan. The loan still had almost Rs 70 Lacs of unpaid amount. And this is what ate up almost 60% of his salary. Apart from the house, he had almost nothing to show for savings. To be exact, he just had a couple of lacs in PF, and less than a lac in fixed deposits.

But he had something else which could be a game changer.

Sometime back, he had inherited a plot of land.

And this plot of land was worth almost Rs 7 Crores at that time!! Yes. You read it right. It was worth more than 7 Crores! And as of then, that plot of land was lying vacant and was not suitable for cultivation.

I was surprised when I came to know of this. I was surprised that even after being a big Crorepati (many times over), he was still working for someone else, and was unhappy with his finances!

What I then told him was simple common sense and none of the usual financial gibberish you get to read on this site 😉

I told him that if he was ready to take a decision based on simple common sense, his life would change for the good. But for that he would have to part with something which he had inherited. And that in itself would require a lot of emotional will power.

He seemed quite eager to know what I planned to tell him. And what I told him is listed in 5 steps given below:

  1. Sell that plot of land and use the money as described in step 2, 3, 4 and 5.
  2. Pay off the home loan of Rs 70 Lacs
  3. Create an emergency fund
  4. Set aside money in fixed deposit which would provide monthly interest equivalent to his monthly salary.
  5. Buy flats and rent them out to create additional streams of income.

This is what I suggested him two years back. And last Sunday, I received a call from him.

But I will share rest of the details about why he wanted to thank me in part 2 of this Post.

 

Mailbag: I have a loan. Should I Pay It Off Before Investing?

Note – I have written about Paying Off Loan Vs Investing for Future debate in detail recently. You might want to read that article – Pay Off Loan or Start Saving & Investing?

In this post, I am trying to give a suitable response to mail I received from a reader named Shivangi. A part of her mail is given below:

I have a loan with outstanding amount of Rs XX lacs. I want to save and invest for future also. But everyone in my family and  friends are telling me to clear off my loans before even thinking about saving or investing for future. Please advice if this is a prudent thing to do or whether one can clear loan and invest parallely?

To be honest to everyone, I may not be the best person to answer this question as I myself have not been in this kind of situation. But I will try to arrive at some conclusion using rational and common sense as my tool.

Readers are welcome to share their own suggestions for Shivangi in comments section.

Mailbag Readers Question Answered

Two Important Considerations

One thing which is not known here is the type of loan which Shivangi is referring to. This is important because different loans have different interest rates and different tenures. For example,

Home Loan : 12% : 20 Years

Personal Loan : 20% : 1 Year

Car Loan : 12% : 5 Years

Loan from Family : 0% : Flexible Tenure

And so on…

Another important thing which needs to be considered here is that when one is planning to invest or save, what is the expected rate of return?

This is because if you are paying 20% in interest for a personal loan, and you want to save your money in fixed deposits, which give an after tax return of 6%, then you are really not being financially intelligent.

Once you have knowledge of these two key important pieces of information, i.e. Interest Rate (&Tenure) of Loan and Expected Rate of return for investments, you need to do a little bit of prioritization…
Debt Prioritization

Now this is very important to understand. A loan taken to invest in a property, which brings monthly rent may not be a bad loan. It is creating an asset which in turn will become a cash-generating machine. But if you buy a car at same interest rates, it is a bad loan as the value of car would depreciate with time. And it will not earn you anything during the time you use it (unless it’s a commercial vehicle).

Please note that by using the word ‘BAD’, I do not mean the bad loans which are a major concern for PSU banks.

Then there is credit card (type-of) debt. Almost everyone will tell you that credit card debt is bad. And generally speaking, they are right. The effective annual interest rate of credit cards is close to 40%!! So in case you do have credit card debt, you should target to clear it off as soon as possible and with a priority greater than anything else.
5 Steps To Invest & Pay Off Loans Simultaneously

Pay Off Loan Or Invest & Save
The Decision

All in all, it is indeed difficult to create an investment or savings portfolio, if you have number of loans running. But it is not impossible. Read the steps below and then I will tell you the most important thing:
  • First of all, you need to recognize the high interest loans (credit cards, personal loans).
  • Get rid of them as soon as possible.
  • Now pay off loans taken to buy liabilities (cars, gadgets) which do not produce a stream of cash.
  • Initiate creation of an Emergency Fund which takes care of unforeseen money requirements.
  • Now if you have any long term, low cost loans (property loan) running, you can think of investing simultaneously as you go on paying off that loan.

And now for the most important and toughest part…

Before you even think of following the above steps, you need to be willing to change your lifestyle as well. And that is because you can only make sensible financial decisions when you are ready to temporarily change and cut down the discretionary expenditures. By discretionary expenditures, I mean buying of goods and services which can be postponed till the time you are financially secure. Just sometime back, I was shocked to know that people are buying wrist watches on monthly installments!! Now according to me that is heights of financial stupidity.

Anyways.. I hope that above information helps Shivangi in her efforts to pay off loan and simultaneously create a stable investment portfolio.

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