Should i Invest or Prepay Loan? is the classic dilemma faced by the borrowers. This catch 22 situation arises when a borrower receives a lump sum amount. The most common sources are an annual bonus, the maturity of deposits, a gift from parents/relatives or inheritance. Normally i don’t suggest to prepay loan especially Home Loan from any amount received through inheritance or gifts from parents / relatives. The only exception is if you have signed proper gift deed or family settlement agreement to safeguard your financial interests. If you prepay loan from gifted/inherited money then it may lead to some legal complications in future. You should prepay loan only from your own sources of fund in such cases. The decision making to prepay loan or to invest is more difficult in the case of Loans like Home Loan. Reason being, the borrower is availing Home Loan Tax Deductions. In other cases like the personal loan or consumer loan, the convenience of EMI is another key consideration. Moreover, the interest rate projected by the bank is less than the actual interest rate. I explained this in my post Mis-Selling of Personal Loans by Bank. An actual interest rate of 14% (Compounded) can be projected as 7.9% (Simple Interest) through magical calculations. It is misleading for a borrower and may result in wrong decision making. Unfortunately, in most of the cases borrower decide against to Prepay Loan and invest in low-return instruments like FD, RD etc.
To avoid such situations, financial literacy is a must. In my opinion, financial literacy should be compulsory in India because of information overdose. In schools, we should teach how to handle matters related to personal finance. When students study simple interest and compounded interest in school then they should be taught practical scenarios. These practical scenarios can be linked to investment and Loans. Similarly, basic concepts of taxation should be introduced at later stages of the schooling. These fundamentals have huge financial implications in life. At the end of the day, it is your hard earned money which is mismanaged by others. Secondly, in decision making like whether to invest or to prepay loan we need to take very pragmatic and logical approach. For the benefit of readers, i will try to keep this post very simple. My only objective is that it should be easy for readers to decided whether they would like to invest or prepay loan.
Invest or Prepay Loan?
1. Loan Type: Whenever you face this dilemma whether to invest or prepay loan, the most important parameter is Loan type. In case of Home Loan, if you are availing tax deductions then you need to find out net interest cost of your home loan. This figure will be different on the case to case basis. The basic thumb rule is to check total interest outflow during FY and reduce Home Loan tax deduction to arrive at net interest cost. Now through reverse calculation using the formula of compounded interest, you can find out effective Interest Rate on Home Loan. It will help to decide whether to prepay loan or not.
In case of unsecured loans like Personal Loan or Consumer Loan, the dilemma is different. Though you are not availing tax benefits and the interest rate is also high. The dilemma is that these loans have a negative impact on your CIBIL Score. Therefore in these cases, the decision to prepay loan also depend on CIBIL score of a borrower. Closure or prepayment of unsecured loans has a positive impact on CIBIL Score. CIBIL Score is a complex topic and you may check my posts on same to understand in detail. As a thumb rule, even after availing unsecured loan if your CIBIL score is more than 750 then you may ignore option to Prepay Loan.
2. Investment Type: Now you need to decide where you would like to invest your money with an assumption that option to prepay loan is ruled out. Key considerations should be Return on Investment, Tax treatment of returns, Risk etc. Assuming, i am planning to invest in FD and ROI is 8.5%. Depending on the tax slab, let say my post tax return is 6.9%. In another scenario, if i am planning to invest in equity with an expected returns of 15%. The risk will be high in equity compared to FD. Depending on your risk appetite, investment amount and other factors you can finalize the investment option & corresponding return projection.
3. Fund Requirement: Before making any decision to prepay loan or investment, you also need to check any short to medium term fund requirement. Reason being, in case you decide to prepay loan then this amount is completely illiquid i.e. you cannot get funds back. In one of the cases, i observed that borrower made a huge prepayment of 10 lacs but has not considered near future fund requirement for some personal expenses. The same borrower then applied for the personal loan to meet his requirement. It is a highly undesirable scenario. In this case, the option to prepay loan should be ruled out without a 2nd thought. Lastly, i am assuming that if you decide to prepay loan then your contingency fund and other insurance requirements are taken care of.
4. How to Decide?: It is very simple. You just compare the net interest rate of the loan and net post-tax return from an investment. If you can generate returns more than the net interest rate of the loan then it is a wise decision to invest the money else you may go ahead to prepay loan. For example, if i can generate the net post-tax return of 12% but my personal loan interest rate is 14% then it will be a wise decision to prepay loan. Another way round if my net home loan interest rate is 8% and return on investment is 12% then it will be financially wise decision to invest the money.
Words of Wisdom: If you decide to prepay loan and opt for the option to reduce your EMI instead of reducing loan tenure after prepayment then this exercise is a waste. I highlighted this in my posts on Home Loan. The objective of prepayment should be to reduce your interest outflow. If you reduce your EMI after prepayment then your interest outflow more of less will remain the same, therefore, the net financial benefit is negligible. In short, you should always opt for the option to reduce loan tenure for financial benefits.
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