Sometimes, we crossover a situation where one has to decide either to clear off their liability or rather invest the surplus cash to earn more income. Well, it’s a situational based decision making wherein the certain characteristics of the liability needs to be compared with the expected returns of the investments. Some of the factors are mentioned below –
1) Cost of Liability vs Expected Returns
The main factor to understand is comparison in the cost of liability with the returns which are expected from investing the amount. For example, if there is a home loan with interest rate of 9.5% and the tenure is for 20 years. Over the same time period, investing in stocks and mutual funds could give 12%-15% returns, then investing the surplus cash would be a better option.
The tradeoff between paying off the debt vs investing should also be considered after considering the time period involved in it. For example, if a personal loan or a credit card debt is of a time period of 12 months and the interest rate is high at 12%. In such situation, closing the debt would be more feasible choice as expecting a return more than 12% in a short span of time would involve investment in a high risk avenue where the 12% cannot be guaranteed.
3) Cash Flow Perspective
While considering an option to either invest or close the debt, one also have to check their own surplus levels and ensure that the loan payments are well within the comfort level and below the thresholds. For example, if the total loan payments are exceeding 40% of income, then there is a need to close them or prepay to reduce the outstanding payments irrespective of other factors like interest rates and returns.
4) Risk involved in Investments
In situations where the decision to invest in considered, one also have to understand the nature of the investments made and returns expected should not only be the sole decision making factor. There are investments which gives a guaranteed returns but the returns are generally lower than the interest to be paid and are also subjected to taxation. For example, fixed income savings schemes gives a return of 7% – 9% whereas the cheapest loan i.e. home loan starts have a rate of interest of 9.7%. Whereas, higher returns generating avenues like stocks and Mutual Funds have higher risk and does not guarantee the returns. Hence, the returns which are expected from the investments should also include the associated risk from the investments.
5) Tax Factors Involved in Loan vs Investments
Some of the debt does includes benefits which in turns reduces its costs. Home Loans have a tax benefits in terms of principle paid as well as interest. Similar to that education loan also gives tax benefit, but only to the interest rate part of the EMI . On other hand, most of the investments like fixed income investments, debt mutual funds are taxable which reduces the returns. Hence, while comparing the loans vs investments, post taxation impact should only be considered which would give a clearer picture of the situation.
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