An experience that a large number of young professional often undergo is deciding between making an investment or paying off their debts. It can be a tough decision as both are necessary and important for the person experiencing the dilemma.
Investing implies building a reserve which can serve as a passive source of income, earn handsome returns and capital gains, and create wealth for the investor in the future. These earnings can help people to buy assets, finance their businesses or help them have financial security post-retirement.
Paying off debts implies a reduction in risks, stress and having higher disposable income and ability to meet financial emergencies. Being debt-free allows individuals to sustain themselves much easier during an economic depression and recession.
In such a scenario, what should a person do? Many people graduate from college and universities and have the liability of student loans; sometimes people are forced to borrow money and take personal loans to meet emergency expenses, which are unavoidable.
So what should a person do? Technically, the smartest course of action while deciding between making an investment and paying off your debt should involve the following variables
- Post-tax interest paid on debt
- Post-tax return on investment
This means, if the rate of post-tax returns is higher than the post-tax interest paid on debt, you should invest and if the post-tax interest paid is higher than post-tax returns on investment, you should pay off your debt. However, the answer is not that simple. Life is never technical or theoretical and is full of variables. You need to take a wide array of variables into account before deciding between making an investment or paying off your debt.
Income and Expenses
The difference between income and expenses is savings. Hence, it is vital to take your monthly income and expenditure levels, along with your monthly savings into consideration before deciding whether to invest or pay off debt.
People who have moderate to high monthly savings post meeting their debt obligations and meeting their monthly expenditure should seek to invest their money. As their debt servicing and monthly expenses are being met comfortably, investing will help them create wealth in the future.
People with a low amount of savings should seek to pay off their debts and reduce their debt repayment burden and interest obligation. Paying off debt will decrease the monthly outgoing in the form of a reduction in EMI payments or EMI tenure, resulting in higher disposable income and savings. The future savings from debt repayment can be used to invest in the future.
Type of Debt to be Repaid
Different forms of debts have their owns pros and cons. While credit card debts and personal loans can be convenient to obtain, these can be very expensive in the long run as they charge a high rate of interest. Whereas home loans can offer certain tax benefits as the interest paid on home loans is allowed as a deduction up to Rs. 200,000/- under Section 24 of the Income Tax Act.
Hence, it is a wiser decision to pay off credit card debts and personal loans, whereas continuing home loan repayments. Hence, if you have a high credit card and personal loan debt, it is wise to adopt a strategy to pay off the debts, and if you have debts such as home loans, it is wise to invest your money.
Using An Alternate Approach
While there are pros and cons of making an investment and clearing off your debts, there is another alternative approach you can use. This implies becoming debt-free, building an emergency fund and then start investing. Although this approach will be difficult for you to start investing early, it can help you lead a debt-free and stress-free life.
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Paying off your debt will help in reducing your monthly interest and debt repayment, as a result of this increasing your monthly savings, and these savings can be once again be used towards repayment and prepayment of the balance of your debt. Once you are debt-free, build a savings corpus which can sustain your 3-4 months of monthly expenses in case of uncertain events such as loss of employment. This corpus can also help in meeting any emergency personal and family expenses, and any other contingency expenses.
Once you are debt-free and build a substantial savings corpus, you can start making investments which can be directed towards your future financial goals.
How to Become Debt-Free?
Cut Down Your Expenses
The first step towards becoming debt free is increasing your savings to repay your outstanding debt. This can only be done by increasing your savings and cutting down on your expenses. Cutting your expenses will not only help you increase your savings but also prevent you from adding up any further credit card debts.
You can cut down your debt by changing your lifestyle. This involves opting for economical alternatives to your daily use products, avoiding unnecessary and frivolous expenses etc.
Review your Insurance Policies
While insurance policies such as life insurance and health insurance are crucial, and it is mandatory to have motor vehicle insurance. Insurance can be a substantial expenditure. Instead of simply renewing insurances taken in the past, at the time of renewal, it is essential to compare similar insurance policies offered by other companies and opt for the most economical one. This can allow you to make substantial savings every year.
Increase Your Income
Most people have a single source of income and rely on their salaries and business income. It is wise to have an additional source of income as it helps in increasing your overall savings and can be helpful in unfortunate events such as loss of job, etc.
People can use their skills, hobbies and talents to freelance and work at night or during the weekend. For instance, you can offer advisory services on the side, find freelance work through your employment network and social media. Also, there are many websites which act as a platform for freelancers and clients to meet and earn freelance working opportunities.
Prepay a portion of your Debt
As you reduce your expenses or add an additional income stream or both, once your savings increase, it is essential to utilise these savings towards prepayment of a portion of your outstanding debt. Although many banks charge a prepayment penalty, it will help you to reduce your debt faster. Also, you can prepay a large portion of debt using your performance bonus, leave encashments, Diwali bonus etc. as these can be a substantial amount and can help you drastically reduce your outstanding debt. Regularly prepaying and reducing your outstanding debt will aid in reducing your monthly debt repayment obligation or your debt repayment period. This will allow you to become debt free faster and start investing.
Bottom Line: The most important variable to consider is You.
While theoretically there is no correct answer to the debate of whether to pay off debt or start investing, the answer lies in you. Your willingness to incorporate changes in life, your long term goals, your desire to be stress-free, your ability to stick to your financial plan will help you answer whether to invest or pay off your debt.
As long as you know what you want and what your final objectives are, which is often being debt free, having a lucrative income stream, providing a good life for yourself and your family and saving ample amount of money for your retirement. With patience, hard work and some smart financial planning, these goals are achievable and never out of reach.