Invest or repay the loan first? – this is one ever-present dilemma most borrowers have, especially young ones. If you were to ask people generally, they would tell you to pay off your loans first. Whether it is right or wrong or something in between, I don’t know, but this is what the conventional view is. The reasons for such a view range from saving on interest costs to the mental peace that being loan-free brings.
But is the conventional view (or wisdom) correct?
Should young earners really wait to clear off all their loans before they start investing?
I don’t think so. At least I don’t fully agree with that line of thought.
Please hear me out on this.
First things first. If someone has just started his career and has a loan to begin repaying (like an education loan or family loan), then they have to pay the regular EMIs. But if they have little to no other savings, then I would suggest starting saving some money on the side as well. They may be tempted to make prepayments (more so if the interest rates are high) to clear the loan fast. But it is never advisable to not have any money with you.
Always save some money separately (more so, if you have no savings at all), even if these small savings give less return than what the loan costs. This may sound odd but it’s necessary.
So if you have no savings at all, then please forget about loan prepayment and investing for the long term. First start saving some money for emergencies. Build an emergency fund where you first save up at least 3 months’ worth of expenses and then scale it up to 6 months.
The next stage of the person may be where they already have some savings (like an emergency fund) and they are now thinking about whether to start investing properly or repaying the loan faster. This is a much more comfortable situation to be in than the earlier no-savings one. Now if you have loans then we need to assess how much is the interest rate. A typical personal loan comes at a 15 percent interest rate and credit cards 35-40 percent. If you have either of these two loans, then it is better to start prepaying them first as these are very costly in terms of interest rates. Better to unburden yourself from these first before you think about long-term investing.
Home loans
But what if you have a home loan too?
Home loan is a very different and docile animal than all other loans. It is a low-interest loan, with tax benefits, taken for the purchase real estate, which generally tends to be an appreciating asset in financial terms (even if you plan to use it). Here you need to compare the after-tax home loan interest rate versus the expected after-tax rate of return on investments that you are interested in.
If you are young and investing for the long term, you might be (and rightly so) considering investing in equity. Historically, equities have given 10-12 percent average returns, which is much higher than what effective home loan rates are when you also consider the tax benefits. Of course, there are chances of not getting the expected good returns on your investments. But there is also a high probability that the average returns will be pretty decent and more than effective home loan rates. So it is worth it in most cases.
That said, there is definitely a case to begin investing before you think about prepaying your home loan. I have written in detail about home loan prepayment scenarios which may appeal to those who want to get rid of their home loans quickly.
Also read | Applying for a personal loan from a fintech lender? Here are five parameters to consider
Key steps
To summarise, here are a few pointers to help you think through this dilemma:
- Make sure you first have proper health and life insurance.
- Continue paying regular (legally required) EMIs for all your loans.
- If you have no savings yet but have some surplus income, start by gradually building up an emergency fund.
- If you have a surplus left, then start clearing off your credit card outstanding dues quickly. After that, go after clearing your personal loan.
- All this while, continue paying your regular home loan EMIs.
- Next, do some number crunching (or ask an investment advisor to do it for you) to figure out how much you need to invest for different goals like retirement, children’s education, etc. And then begin saving for these long-term goals.
- Only after you have taken care of all the above aspects, and if you still have surplus left, you should go for home loan prepayment if you want to.
Disclaimer: Choosing to invest instead of prepaying a loan may or may not be the best option for everyone. It depends on individual circumstances, and risk appetite and hence should be dealt with differently. Please consult your investment advisor for this.
