We often find ourselves under a dilemma when a decision has to be taken regarding allocation of surplus cash, whether we should clear off existing liability or invest it into other avenues which can either generate regular income or appreciate with growing markets.
Normally such decisions are more emotional rather than logical as we see an opportunity to get rid of a liability which gives a sigh of relief. But such step may not be the best financial decision as it may cost a lost opportunity where the result could have been better. In situations like this, one must understand the characteristics of our existing liability versus expected returns from the new investment avenue. To help us compare better, below are a few considerations-
1. The Cost Of Liability Vs Expected Returns
The difference between a cost of liability and expected returns from the investments becomes one of the most important factors to be considered. For example, if there is a home loan with an interest rate of 9.5% for tenure of 20 years and over the same period of time investing in stocks and mutual funds could give 12%-15% returns, then it is better to put the surplus cash into an investment folio. An alternative way could be to invest the amount for next 8-10 years and use the accumulated amount to close the loan, by this we can close a bigger chunk of the liability.
Tenure is an important factor for consideration when we are trying to analyze gain from paying of an existing debt versus a would-be investment. For example, if a personal loan or a credit card loan repayment period is of 12 months at an interest rate as high as 12%, it is better to pay off the Debt Funds first. In such situation, expecting a return of more than 12% from a short term investment would involve high risk, and simultaneously the return maybe unwarranted.
3. Cash Flow
While considering an option to either invest or pay off an existing loan, one should check the level of surplus to ensure that the loan payments are always below the thresholds. For example, if the loan payments exceed 40% of our income, then we should pre-close the existing loan or pre-pay to reduce the outstanding irrespective of other considerations, i.e., interest rates and returns.
When considering an investment folio, we should not limit our understanding to the nature of investment and expected returns alone. Risk evaluation is serves critical to deciding whether a particular folio is good enough to be considered for investment. There are investments which give guaranteed returns but the rate of interest paid on such return is much lower and also subjected to taxation. For example, fixed income savings schemes give a return of 7%-9% whereas higher returns generating avenues like stocks and Mutual Funds have higher risks and do not guarantee returns.
5. Tax Factors
Some loans do offer tax benefit which in turn reduces its costs. For example, home loan has tax benefits on both its principal and interest part of the EMI (Equated Monthly Installment). Similar to that, education loan also gives tax benefit, but unlike home loan, here the benefit goes to the interest part only. Looking at the overall tax benefit feature of an existing loan, we should decide whether to close the existing loan or invest the surplus in some fixed income folio rather than investments whose returns are heavily taxable.