I have a car loan that I have to pay for another five years at 10.05% interest rate a year. The equated monthly instalment (EMI) is Rs.13,103 per month. I have Rs.1 lakh in hand. Should I foreclose the car loan or should I invest the amount in mutual funds so that I can get returns higher than the interest rate that I am paying for the car loan? If I foreclose the loan, I believe the EMI will get reduced by Rs.2,500 and the reduced amount can be used to invest in mutual funds. Also, should I invest in a lump sum or via systematic investment plans (SIPs)?
It is good to plan your finances and ensure that money works hard for you. As you rightly mentioned, there are two options: either invest the money for the long term, or do a partial prepayment of the loan. The key to the decision would be where the money is going to generate a better return on investment. In the first option, if the Rs.1 lakh is to be invested, the objective is to earn higher than the interest rate on the car loan, which is 10.05%. This may not be possible if you consider investing in safe asset classes like bank fixed deposits. And we have not even considered taxation.
Therefore, asset classes that take risk, such as equity, have to be considered if we want to outperform the targeted return. Your options could be to invest either directly via stocks or through equity-based mutual funds. It is recommended that you opt for mutual funds due to the various benefits offered, such as professional management, diversification, and affordability.
Based on your risk appetite, you can choose appropriate mutual funds. If moderate to medium risk is what you are looking at, then hybrid funds can be considered. In case of medium to high risk, categories such as large-cap, multi-cap and mid-cap can be considered.
At the same time, don’t get too aggressive on the assumption that markets have bottomed out. It is not possible to predict the bottom of the markets as there are far too many variables to consider.
At the same time, this option is similar to taking a loan and investing, and where the cost of borrowing is 10.05%. So, you are paying an interest and trying to outperform the cost of borrowing along with earning over and above it.
The second option is where partial prepayment of loan does not have any prepayment penalty and will reduce the EMI, which will in turn lead to starting a monthly investment of the EMI saved per month. In this option, an SIP can be started in the above mentioned asset classes and can be done for a minimum term of your car loan, i.e., five years, if not more.
This option is recommended as not only does the prepayment reduce the outstanding loan and interest amount, staggering the investment over five years brings discipline to your savings along with benefits of rupee cost averaging.
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