Reduce debt or invest with extra funds?
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A common dilemma facing many people is whether to use any additional savings or any unexpected sum received to build their investment portfolio or pay off debt. Being completely debt-free before starting to invest may be an unrealistic goal.
A large debt such as a mortgage is paid off over many years, given the size of these loans. Putting off investments till such time all loans are repaid may leave you with little or no time to build a corpus, which would put all your other financial goals at risk. Typically, investments and debt repayments happen in parallel.
A portion of the income is used to meet debt obligations while the savings are invested to meet future goals. Here are some ways that can help you make the decision.
Crunch the numbers
The simple way would be to go with the option that gives the biggest bang for your buck.
“This can be decided by making a cost benefit comparison of both the options. In case of investment product, the post-tax return can be calculated by considering the goal horizon, risk appetite and the chosen instrument. Tax on interest and maturity proceeds will vary based on the category of product. In case of a loan, the interest saving on prepayment of loan should be reduced by prepayment penalty, if any, and the foregone tax benefit, which can be compared with the above to arrive at a decision,” said Prakash Praharaj, founder, Maxsecure Financial Planners.
Let’s take an example. If the post-tax cost of a mortgage is 7%, then unless the investment options you were considering gave you post-tax returns of more than 7%, you should go with repaying the debt. If it did bring in more than 7% then any additional savings or money would go to investments. If you paid 18% on your credit card outstanding, then unless your investments are able to bring in more than 18% post-tax, you would be better off paying the credit card dues before considering investments.
The terms of borrowing will also determine how you will deal with debt.
In case of a mortgage or a vehicle loan, the equated monthly instalment (EMI) is the obligation that has to be met each month. There is no penalty as long as that is paid. In case of a credit card balance, the entire amount outstanding is due for payment, and paying just the minimum amount due is not the end of the obligation. You will be charged interest on the balance as well as additional spending.
“It is prudent to rank you debt on the basis of the interest rate that your are servicing. So, on a priority basis, you should look to close credit cards and personal loan outstanding, where the interest rates may be 12-36%. No investment product will provide you with a yield to match these heavy interest rates,” said Rajiv Raj, co-founder and director, CreditVidya, a credit advice and planning company.
The argument for building investments over paying off debt primarily rests on the benefits from compounding that accrues to a portfolio when investments are started early.
But what is overlooked is that just as the interest earned on interest adds to the total returns from the investment over time, the interest that becomes payable on the interest due adds to the total outstanding debt. The impact of compounding will be higher upon the loan or investment with the higher interest rate.
“In case of compounding, there are three elements—interest rate, frequency of compounding and time period. Presuming the time period is same, the interest rate and compounding frequency will be deciding factors,” said Praharaj.
Beyond the numbers
Apart from the cost aspects, the incentive to pay down debt comes from the need to protect the credit score from the effects of poor credit habits. A bad credit score will affect the accessibility and cost of any credit needs you may have in the future. There is also an emotional aspect to being debt-free. The security that comes from not having the debt obligation to worry about may be a big incentive for most people to pay off debt before investing.
“Any lump sum received from a bonus, inheritance or gift should be carefully evaluated for strengthening your financial foundation. If you have been running low on your emergency fund, build that up first. If you do not have adequate life and health insurance, buy those. Then explore the option of paying off your debts or investing further in your financial portfolio. Bad loans need to be paid off first. However, good loans can continue,” said Amit Kukreja, founder, WealthBeing Advisors.
The risk of having to give up goals for want of funds is what drives people to invest to accumulate the corpus required to meet them even if it meant servicing high-cost debt for longer.
Paying high-cost debt may be a choice most people may make given its effects on current and future finances. The quicker this is done, the faster your savings are freed up to work for your goals and needs.
One way of motivating yourself to work down the debt fast is to see how else the amount paid as interest on wasteful consumer debt such as credit cards and personal loans could instead have been used to your benefit. You could have used it to meet some of your regular essential expenses such as food and transport.
Make sure you have a firm plan in place if you choose to invest rather than pay off debt. If the saving is just going to lie in the savings bank account and you end up spending it over time, then you lose both ways. Neither is debt reduced nor is there any accumulation in the portfolio.
Come up with a plan that considers your attitude to debt and your financial goals before you decide how best to use your funds.
A middle ground might work best where you concentrate on paying off your high-cost debt even while you set aside a portion of savings for long-term goals like retirement, especially when there are benefits like a matching contribution by the employer and tax benefits.