If you are paying off a loan (say a home or car loan) and suddenly find yourselves with some extra cash, you might be wondering whether to put it towards paying off the loan or investing.
It’s a tricky choice, but we’ve got some insights to help them make the right decision.
There are basically two lenses that they can use to solve the dilemma:
LENS 1: RATIONAL LENS
The logical starting point is to compare the expected future return from your investment vs your current loan’s interest rate.
If,
Expected Return from Investment >= Loan Interest Rate + Safety Margin (4%) = Invest
Expected Return from Investment < Loan Interest Rate + Safety Margin (4%) = Prepay Debt
Why do we have a safety margin?
- Buffer for rising interest rates – In the last few months the loan interest rates have increased from 6% to almost 8-9%. To provide for such rising rates an additional buffer is required.
- Buffer for unexpected Investment returns – There can be times when the Investment returns do not turn out as expected, for such lower-than-expected return outcomes a buffer is required.
Here is an example of how this works.
Assume you plan to invest in Equity Mutual Funds and their return expectation is around 12%.
Their current home loan rate is at 9%.
So,
Expected Return from Investment at 12% < 13% (i.e. Loan Interest Rate of 9% + Safety Margin of 4%)
This means from a rational point of view, it’s better to ‘Prepay Debt’
LENS 2: EMOTIONAL LENS
Sure, the rational perspective makes logical sense. But let’s be real, when it comes to making decisions, emotions can play a huge role too. In fact, sometimes our emotions are just as important as the rational side of things, if not more.
So, let us also wear the emotional lens and check how you feel about the outstanding loan and monthly EMIs?
Question 1: Are you stressed that you are a single earner and have unstable job/incomes?
- If yes, it is better to prepay debt.
Question 2: Do you constantly worry about your large outstanding loan amount?
- If yes, it is better to prepay debt which helps reduce the stress and burden.
Question 3: Are you frustrated that your monthly EMIs take away a large part (>30%) of their monthly income?
- If yes, it is better to prepay debt.
Summing it up
- There are two lenses to evaluate this dilemma of prepaying debt vs investing.
- The Rational lens is where you can compare the expected investment returns and the loan interest rate. The Emotional lens is where you make decisions based on how you feel.
- While both lenses are equally important, you can use the above framework to prioritize.