One of the questions that bothers a lot of people is whether they should invest their savings or use them to pay off their outstanding loans.
I have encountered a few cases where a significant amount of money was kept in a savings account that was yielding 2.5-3.5% returns while an outstanding loan costing 8-9%. Most of the time, it’s because of indecision regarding the usage of money and a lack of understanding about compounding.
Ideally, staying debt-free is the best option. It drastically improves your financial health, brings peace of mind, and opens up more options in your life. However, sometimes having debt makes sense. Below are the scenarios where not paying off your outstanding debt makes more sense. The point to be noted is that all these scenarios should be applicable:
- Interest rates on your outstanding debt are lesser than the expected returns on your investments: If your investments are generating at least 2-3% higher returns (net of all the taxes and expenses) over the tenure of your outstanding debt, it makes more sense to invest and not pay off the loans. However, one needs to be quite certain about the investment outcome. How can you be certain? For that, your investments should be done with a high degree of margin of safety which means it should be done at very lucrative and cheap prices compared to the worth of the asset. How do you decide the worth of any asset? This comes from skillsets developed over years of experience.
- Outstanding debt should be manageable: The value of your investments should be equal to or more than the amount of outstanding debt to avoid bankruptcy in case of a sudden loss of income. Or at the minimum one should have a contingency fund to service EMIs for at least 12 months in the case of loss of income. In case the debt is more than the investments, a term insurance plan over the tenure of the debt is absolutely necessary. Needless to say, having health insurance coverage is a must irrespective of any scenario to safeguard your savings.
How you use debt can either break you or help create wealth for you. The key to wealth creation is to be aware of your options and ensure debt levels that are completely manageable and are costing lesser than the investment returns.
It’s a sin to have money in low-yielding avenues when the outstanding loan is milking your finances.
Originally posted on LinkedIn: www.linkedin.com/sumitduseja
Truemind Capital is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at connect@truemindcapital.com or call us at 9999505324.
