Should I Pay Debt or Invest?

Many of us face this dilemma – “Should I use surplus money to pay off existing debt or should I invest?” It is not an easy decision to make. But give me an answer – why someone should take a car loan at 11%, when his Fixed Deposits are just earning taxable 8%. 11% vs 6% tax free (depending on tax slab) = –5% (on 5 lakh loan losing 25000 yearly) – it’s a simple calculation but I have seen n number of people doing this mistake. But in other cases calculations are not so simple.......
Steps to take and factors to consider before you make the right choice

List down your debts

List down all the debts that you have either in an Excel spreadsheet or on paper. Write down the debt amount, interest rate and duration for each loan. Indicate if any of the loans qualify for tax deduction. For example, if you have taken an education loan either for yourself or your spouse or child, the interest payable is eligible for tax deduction. The principal and interest amount in a home loan availed of is eligible for tax deduction.

Do you have an emergency fund

Check your cash and bank balance. Do you have money to take care of emergencies, unfortunate events like medical issues, job layoffs etc. The amount should be equivalent to 3 to 6 months of your expenses depending on your lifestyle and family situation. (if you are single bread winner go for 6 mths) If you do not have enough emergency fund, use some of the surplus amount to manage that.

Calculate

Check the interest rates. Normally the personal loans or credit card debt have higher interest rates and are basically consumption oriented. It is best to pay off these loans first as the interest would only be eating into your savings account and you do not build any asset with these loans.

I got this email from citi bank – I don’t know any investment which can beat this rate.

Pay off strategy

You have to compare the interest amount you save when you payoff the loan versus the after tax returns you generate (plus tax benefit on EMI) to decide whether it is better to pay off the loan or use it to save on tax. If you decide not to pay off, the surplus amount can be invested which will also give you returns or increase your wealth. If you take a home loan with the following details –

Loan Amount	Rs. 20,00,000
Interest rate	10.50%
Tenure	10 years

You will have to pay an EMI of Rs. 26,987 per month and over 10 years, it will be Rs. 12,38,440. If you have a surplus amount of Rs. 2,00,000, 2 years after the loan tenure started, you have two choices –

1. You can pay Rs. 2,00,000 at that time. This will save you Rs. 2,32,000. But you will lose some amount eligible for tax deduction.
2. You have the option of investing Rs. 2,00,000 in a large cap equity based Mutual fund, you could have earned returns around 10-12% and the total investment would be worth more than Rs. 3,20,000 (even if returns are taken at 12% p.a.). Though returns are not guaranteed, if you have the ability to take risk and tolerance for risk, you might be better off investing in equity mutual funds in this scenario.

Emotional Aspect

It is important to consider your emotions. What do you like more – Being debt free ortaking some risk by using the surplus to invest in some assets which might give you better returns. If you are not a good saver (my sister’s case) – it’s good to continue EMI (because it’s compulsory) & try hard to save (which is optional). THINK

You should know your risk taking ability and tolerance. Would you feel awful, if you realise later on that the equity markets or any other investment that you understand did very well and you would have made much more money investing there than paying off debt? Consider your personality and emotions before taking the decision.

Pay off debt Vs invest

To conclude, I would like to say that it is better to pay off debts that are costly to service. Paying off debt saves money. At the same time, it is important to invest in assets to generate returns and build wealth. You should use some of the surplus to pay off loans like personal loans and invest the remaining amount in assets that give optimum returns depending on your risk profile and financial goals.

Pay off the smaller loans first so that you feel good about these wins.