MANAGE YOUR DEBT: While there is an impulse to pay off loans with unexpected bonuses, etc, it may not always be the best option
Today, many are able to upgrade their lifestyles at a much faster pace. People become proud owners of their own homes and cars and manage to travel the world frequently. All this has been made possible with the easy availability of loans which enables them to afford these luxuries much sooner, compared to a couple of decades back. But once the joy of building asset or the period of consumption wears off, then one realises the extent of liability. Especially when EMI starts and reduces the monthly cash flow of the household.
At such point of time, when there is a spurt in cash flow by way of some unexpected business profits, bonuses and salary hikes, our first impulse is to pay off the loans and reduce the liability. But that may nor may not be the best course of action. Let us see the factors one should consider.
Is EMI payment leading to cash crunch?
The first factor to consider is the cash flow a household has. Is the EMI amount a big drag on monthly flows or is a large financial goal coming up in the near term? If post EMI payment family feels a cash crunch on frequent basis then they should consider pre-payment of the loan, at least to such an extent that balance EMIs can be brought down to a manageable level.
Also, if there is any big financial goal (for example, children's higher education or marriage) coming up in near term and you do not have a corpus set aside for it separately, this cash flow might come in handy and help meet the goal easily.
Investment avenue and expected returns
The second factor is the investment avenue under consideration and expected returns. The option to invest the money and not pre-pay the loan should be considered only if the investment rate of return expectation is at least 2% more than the rate of interest of the loan. If, the family is planning to invest the money in a low return generating asset like a fixed deposit, they would be better of pre-paying the loan. On the other hand if they have a slightly aggressive risk profile then they can take exposure to equities and can expect to generate returns much higher than the loan interest rate over a period of five years plus. Investors who aren't very well versed with stock investing can take the mutual fund route too. Hence, in case of personal loans with high interest rates of 12% plus it is always a better idea to pre-pay the loans.
Time of loan tenure
Another factor to consider is the time left to complete the loan tenure. If you have a long period of tenure left and are expecting to generate returns more than your loan interest rate, then you would be in much better position. However, if your outstanding loan tenure is lesser, closer to five years or less, then there would not be much monetary difference in the decision to pre-pay loan or reinvest.
Taxation
The third factor to consider is taxation. If the loan you wish to pre-pay is a home loan, it is likely that as of today you are enjoying tax benefits under section 80 C and Section 24. Will the pre-payment of the loan affect your tax planning? If yes, you will have to consider other investment options covered under Section 80C to continue to enjoy the benefits. This will have an impact on your annual cash flows as there will be outflow for the Section 80 C investments and the additional tax payouts.
PAY OR INVEST?
- The option to invest the money and not pre-pay the loan should be considered only if the investment rate of return expectation is at least 2% more than loan rate
- In case the loan offer tax benefits, consider investment options that will offer similar benefits
The writer is head products, Anand Rathi Preferred
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