So you have been awarded with a hike or bonus in your salary, Congratulations!. Now you are faced with a huge predicament: "Should I use the extra income to pay off your loans or save for your future?"
You cannot miss out your loans at any cost and should meet your monthly minimums at least. But the question of loan or investment should arise only if your income exceeds your expenses and minimum payments combined. After the minimum payment has been made, you can start to decide whether to pay off your loans or invest by using the surplus.
The decision depends on your risk tolerance, interest rates, personal feelings concerning your debt etc. But there are a few guidelines you can work by:
Liquidity: Evaluate your liquidity position before you decide your action with the surplus. If you are rich in assets but poor in cash, then plan to improve your liquidity factor by investing the amount in debt instruments instead of paying back the loan more than what's necessary.
Employment security: How much are you settled in your current employment? If you happen to face a job loss, will you still be able to manage your EMIs? Ensure that you have an alternate source of income like rentals, income of spouse etc. that can help you glide over the phase until you secure a new job. It is best that you secure your employment such that you can plan your investments with better freedom.
Emergency needs: Depending on your employment security and household conditions, you should have at least 3 – 6 months of expenses stashed away for emergencies. It wouldn't be wise of you to pay of your 10% interest student debt in bulk only to end up taking a 23% interest on credit card to meet an emergency/unexpected situation.Interest vs. Returns: Let's say that our test subject Mr. Raj carries ₹ 7,00,000 as his student loan with 9% interest rate and a term of 10 years. Every month he has an excess of ₹ 10,000 (without including his minimum payment). He ends up paying it all to the bank and cuts off the repayment time from 10 years to less than 6.5 years. Genius, right
|Loan Principal||₹ 7,00,000 |
|Repayment Period||10 years|
|Minimum Payment per month||₹ 6358.34|
|Monthly Excess Income||₹ 10,000|
|Pay of loans before starting to invest||Make minimum loan payment and invest the surplus|
|Approx. ₹ 5,00,000 ||₹ 7,00,000 |
*the figures mentioned in the table are hypothetical and for explanatory purposes only.
It is clear that over a course of 10 years, Raj has ended up losing around ₹ 2,00,000 (assuming9% returns) after not using his surplus to invest for the first 6.5 years.
Financial goals: Do you have a plan to buy a house for yourself in a few years? Then you might want to keep your funds invested in appropriate instruments that can yield sufficient returns to help you meet the need rather than paying off your loans.
Risk profile: Investments can be volatile, especially if you decide to invest your money in equities. Will you be able to balance out the negative returns without letting it affect your other expenses? If you have higher tolerance towards risks, you can invest your money and reap more benefits. If your financial condition expresses low tolerance for risk, then plan your actions accordingly.In conclusion, the answer is not same as everyone. It depends on their mindset and should be dealt differently for every individual. Ensure that your plan suits your attitudes and financial goals. A combination of paying a slight extra principle of your loans every month while investing a small amount works the best.