Sunday, January 17, 2010

Should you Invest Or Repay your Loans?

Found this article on Outlook Money (Dec 30, 2009 issue) and thought to share it on this platform.

The traditional wisdom says that you probably shouldn’t be investing while in debt unless you can reasonably expect to outperform the interest rates that you’re paying. In other words, if you’re carrying a high-interest debt, you should focus on getting out of debt instead of building your portfolio. This sounds simpler than it is.

What you should do will depend on two factors: the rate of after-tax interest that you are paying on your debt; and the after-tax return that you will be earning on your investments. Understand the types of debt and their impact on your financials.

One type of debt is the high-interest credit card debt, which is mostly used to meet comforts and luxuries, not needs. This kind of debt will eat your financials like a termite and should be avoided unless absolutely necessary.

The other type of debt is the lower interest rate variety, like housing loans, education loan, etc. Often the interest payable on these loans is either fully or partially tax-deductible, thus making them even more attractive.

If your cash flows support you in terms of meeting the debt prepayment and you still have surpluses, you can continue to invest and pay your debt at the same time. For example, you have a housing loan for which you are paying monthly EMIs. Treat this EMI as monthly rent and continue the debt, as you also get tax benefits for the interest portion on the housing loan. Invest the surplus in the asset type depending on your risk appetite. There’s certainly no harm in carrying the loan while building up your investments for the future. In fact, if you wait until you’ve paid off your loan over 15 to 20 years, you’ll find yourself in a very difficult situation by the time you turn your attention to the future. In case your cash flows are not very predictable, and you have surplus today, it will be better to clear the debt and reduce or zero your liabilities rather than investing the surpluses. Imagine a situation where you have invested in the market with the hope of generating returns that are more than what you are paying for the debt. Suppose the markets fell and your investments lost half of their value, while, at the same time, your cash flows took a hit. You will have a couple of painful choices to make—either you sell your investments at a loss and meet your commitments, or borrow afresh at a higher rate. It is better to clear your debts and then start your investments. The illustrations below will help you decide whether to continue the debt or to retire it.

Example I. You have an outstanding balance of Rs 50,000 on your credit card and you are paying 24 per cent annually and the interest is also not tax deductible. In such a situation, you should invest only if you think you can earn over 24 per cent per annum. Historically, the long term returns from equities have been around 18 per cent. It would be detrimental to your financial health to invest in a situation like this. So, clear the debt and use credit cards only if absolutely necessary.

Example II. You have a housing loan of Rs 20 lakh at 9 per cent, to be paid over 20 years. Let us also assume that you are in the 30 per cent tax bracket and as per current tax laws interest up to Rs 1.5 lakh is deductible from your taxable income. This will bring down the cost of your loan further. In such circumstances, it will be wise to continue your EMI of housing loan and the balance surplus is invested in long-term assets to generate returns higher than the interest cost.

What are you waiting for? Work out the numbers, see which is financially economical and just execute it even if it means you have to make a few painful decisions. Remember: “No pain, No gain”.


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