We Design Your Financial Destiny


(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Prepay, Invest or Spend? What’s The Best Choice For You.

You have received a lump sum amount (e.g. a gift, the annual bonus or a legacy).

Now, you are in two minds — should I reduce my debt or invest this money?

Sorry, there’s a third mind too — or should I spend it (on a foreign trip, the latest smartphone or a diamond set… well, there is no end to desires.)

This is the common dilemma faced by many people.

But, there is no single and simple solution to this. It all depends on your specific circumstances.

So which option is in your best interest?

Here’s a simple checklist to arrive at the most appropriate solution.

1. Loan Cost i.e. the Interest Rate

This, quite obviously, is one of the most important factors.

If the interest rate on your loan is more than the expected return on investment, then it is no brainer that you must prepay the loan. There is no point in earning less and paying more.

a) High Cost Loans
If your loan is a personal loan or credit card outstanding, no investment will probably match the interest cost. 

Prepayment of such loans should, therefore, be your first priority.

Spending or investing has to be deferred to some other day.

b) Low Cost Loans
Home loan, however, is a slightly tricky choice.

Interest rate on home loan is normally quite competitive. Plus, you are eligible for tax deduction on the interest payments. Thus, the effective interest cost is quite low (presently, at around 6-8% p.a.).

Fixed-income investment vs the loan
You can probably earn similar returns (presently around 6-8% p.a.) from the fixed-income debt investments. But, this interest income is taxable in most cases (PPF and Tax-free bonds being the two notable exceptions here).

Therefore, if your financial profile dictates that you should be investing in debt products, it’s best to prepay the loan. There is either a loss or no significant cost advantage between the loan cost and the investment yields.

Equity investment vs the loan
It is quite reasonable to expect around 12% to 15% p.a. returns from equity investment. Thus, a huge gain of around 4-7% p.a. is possible by investing the money, instead of prepaying. So cost-wise, investing your lump sum money is the right choice.

Beware! Here, cost should not be the sole criteria in your decision making.

Firstly, interest payment is “fixed and certain” every month. Whereas, returns from equity are “neither fixed nor certain”.

Secondly, the 12% to 15% p.a. expected return from equity is possible only over long term, certainly not less than 5-7 years.

Therefore, you may invest in equity, instead of prepaying the home loan, only if you have
- the risk appetite for investing in equity
- long term investment horizon, and
- in the absence of regular income from equity, you would still be comfortable paying the EMIs.

prepay-invest-or-spend
Prepay, Invest or Spend  Multiple choices can be a real challenge.

2. Debt-to-Income Ratio i.e. the EMI Burden

It is wise to keep the debt within reasonable levels.

What are these reasonable levels?

If you are servicing a home loan, the thumb rule is to keep the total EMI payout at a maximum of 50% of the take-home monthly salary.

Whereas, for personal loans or vehicle loans, not more than 15-25% of your take-home pay should go towards EMI payments.

And for credit card outstanding balances, the ideal limit is zero. In the worst case scenario, don’t let this exceed 5%-7% limit of your salary.

So, now you know what to do.

If you are not within the reasonable levels defined above, the most prudent thing would be to bring down the debt burden. Your lump sum money is a great opportunity to do this and you should not let this chance go waste.

However, if you fall comfortably within the aforesaid limits and also meet the cost criteria discussed earlier, you can consider investing instead of prepaying.

3. Need vs Want i.e. the Peer-Group Pressure

We don’t earn money just for the sake of increasing our bank balance or net worth.

Ultimately, it has to satisfy our needs and desires. Ultimately, we should be able to show-off our materialistic possessions to our friends and neighbours.

Therefore, spending money is an aspect, which cannot be given a low priority.

However, like good loans and bad loans or good investments and bad investments, we also have good spending and bad spending… commonly referred to as Needs Vs Wants.

This, of course, is a grey area. What I may consider as a wasteful expense, may be seen as a need by someone else.

So, I leave it to you to decide.

Before you spend, think... and think twice.

Splurging may give short-term happiness, but long-term pain. Showing-off may be a pleasure, but may end-up ruining you. So, it may probably be a good idea to keep your fantasies under control, and not become too extravagant with your money.  

This, in a nutshell, is the simple strategy to arrive at the best possible outcome to your Prepay-vs-Invest-vs-Spend puzzle.

(Or, a still simpler strategy would be to drop in an email to me at contact@wealtharchitects.in.)

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

101 Classic Tips Money Gyaan

You Learn A Lot By READING... And Even More By SHARING.

Share Button

Ignorance is like a SIGNED BLANK CHEQUE... anyone can MISUSE it.

Subscribe via Email
Powered by Blogger.

... Three VALUABLE Tips ...

1. Why Mutual Funds Won't Survive On The Planet Mars
No Mutual Funds on Mars
Mutual Funds would be a totally ALIEN concept on planet Mars.

 


2. 10 Key Features of 'Standard Individual Health Insurance'
Standard Individual Health Insurance
Salient aspects of the Arogya Sanjeevani Policy.

 


3. Refinance Home Loan In Early Years (For Maximum Gains)
Loan Refinancing
Think before you make your move to refinance your loan.