Investment and Debt Repayment - How should you choose between the two?

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If you’re in your late 20s or older, chances are, you may have some kind of debt in your financial portfolio. Perhaps a personal loan you availed for meeting your travel expenses? Or a housing loan you took out to build your dream home? Or maybe a couple of credit cards that you’ve been using to fund some big-ticket purchases?

Whatever kind of debt your portfolio includes, there’s no denying that you also need to include investments in your kitty. Whether you want to build an emergency fund or a retirement fund, you need to diligently invest for every kind of financial goal.

The bottom line is that it’s just as important to repay your debts on time as it is to invest for your future. So, if you were to receive a lump sum payout now — perhaps as a bonus at work or as a tax refund — what should you do with the money? Should you pay off your debts, or should you use the funds to invest for your future goals?

The short answer is that the right choice varies from one individual to another.

The longer version involves considering various factors before you make a choice between investing and debt repayment. Let’s check out what these factors are.

Things you should consider before you make a decision

To figure out what you need to do with the extra cash in hand, here are the top parameters you need to think of.

1. The rate of interest on your debts

The cost of your debt is very important, particularly in comparison with the rate of returns you expect to earn from your investments. If you can earn more from your investments than what your debts cost, it may be a better idea to invest rather than repay your loans.

For example, say you have a housing loan with an interest rate of 6.5% per annum. And you have the option to invest in a debt instrument that offers you annual interest at the rate of 7.2% per annum. In this case, investing is obviously a better idea since you earn more than you could have paid off.

But if you’re dealing with high-interest debt like a credit card bill or a personal loan, you may want to consider paying that liability off first because they typically cost a great deal of interest.

2. The extent of volatility in your preferred investments

Merely pitting the cost of debt against the returns from your investments is not enough. This is because the cost of your debts is fixed and known in advance, but the returns on your investments may not be as accurate. Most high-return investments are volatile, and the exact rate of returns cannot be determined precisely beforehand.

Of course, in the case of some investment options like fixed deposits and bonds, you will know the exact rate of earnings before you invest. However, this is not the case for market-linked investments. So, before you make a choice between debt payoffs and investments, consider how volatile or fixed your preferred investment avenues are.

3. The kind of debt you have

The kind of debt you have also matters. Some debts are better paid off in advance, so you can avoid the excess interest that you have to pay over the repayment tenure. But other debts could actually be beneficial to you over the long term.

Take the case of a housing loan, for instance. In India, as per the Income Tax Act, 1961, you get the following benefits on your home loan repayments —

A deduction up to Rs. 1.5 lakhs u/s 80C for principal repayments
A deduction up to Rs. 2 lakhs u/s 24 for interest repayments

So, if you close your home loan sooner, you may lose the tax benefits they offer you each financial year. Education loans also offer you tax savings. In such cases, you need to compare the additional interest costs against the tax benefits you stand to enjoy. And if the latter outweighs the former, it’s a good idea to keep paying your loans as per the schedule and use the extra cash to invest instead.

4. Your job situation

If you have a stable job, it may be easier to decide what to do with a little bit of extra cash. Even if you end up making a poor choice, you can compensate for the same with your income next month. For example, say you use the funds from the windfall to pay off a debt but later realise that you should have perhaps used the money to grow your emergency fund. In this case, you can use a part of your next paycheck to contribute to your emergency savings.

But if your job situation is a bit more volatile, or if your income is not quite steady yet, what you do with that bit of extra cash is all the more crucial. Typically, it may be a good choice to prioritise investing or saving for emergencies. That’s because if you use the extra funds to pay off your debt, and if you lose your job, you may have to borrow money again to meet your financial needs.

That said, the type of debt and the interest rate also matter. If you have a high-interest debt, it may be a smart idea to pay it off sooner than later so you don’t end up with the burden of steep interest.

Summing up: Which option should you choose?

Okay, so you now know what factors to consider before you make a choice between investing and repaying debts. But which option should you eventually go with? Here’s a quick summary to help you make the right decision.

Choose to invest your surplus funds if —

You have a low-interest debt
Your investments earn you more than the cost of your debts
Your debts actually give you other financial benefits like tax savings

Choose to repay your debts with your surplus funds if —

You have a high-interest debt
Your debts don’t give you any financial advantages
You want to build or improve your credit history

If you can afford to, however, you can use a part of your surplus funds to pay off debt and then invest the rest of the money. This way, you can meet both these financial requirements easily.