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.

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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3 things to do before investing in stock markets


All of us want to make money in stock markets. And given a chance, we would love to become Warren Buffet (lol) 🙂.  But we believe that stock markets are inherently risky. And when dealing with risks, one should be cautious to start with. According to us, there are 3 very important things which should precede investments in stock markets –

Build an Emergency Fund
The goal of emergency fund is to have around 6 months of expenses in savings. This can be for more than 6 months too but minimum we suggest is 6 months. The emergency fund is not an investment. It is simply a pool of funds which can be dipped into in case of emergencies. One should not risk emergency funds to earn higher interests. This fund should be parked in only the most liquid of assets like Savings Account. Though this may seem like a lot of money being used to earn minuscule returns, the fact is that it helps in building personal financial security. If you decide to invest in stocks before having an emergency fund, you may have to sell your investments at a time when markets are down and you would then be forced to lose money.

Pay off high interest debt
Paying off high interest debt, especially those of personal loans and credit cards is a must. Many such debts have a 15% + rate of interest. And since it is nearly impossible to find a guaranteed return like that in stock market, it makes sense to pay off these high-interest-rate debts. (One can continue to have long term debts like home loans, etc even when entering the stock markets)

Understand yourself (& your risk appetite & investment time horizon)
Stock markets are not for everyone. If one is not comfortable with occasional rise and fall in portfolio value, then stocks can give sleepless nights. One should never invest more than one can afford to lose in the short term. Before investing even a rupee, one should understand that there are 2 type of risks associated with stock investing; namely company risk (possibility of company going down) and market risk (possibility of overall market going down). There is no way one can avoid these risks. But these can be reduced. And as they say, it is not about avoiding risk that matters, but how to manage the risk that is more important. Another must do for future investor is to figure out why they are investing? Answer to this question itself will give them a direction on where to start. 

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