Should I prepay my loan or Invest the money?

by Amandeep Singh

in Personal Finance

Should i prepay my loan or reinvest that moneyRemember the time when you took a Personal loan to fund a requirement for your parents? Or, you had to take a loan for purchasing a vehicle or the loan was for your marriage or any other reason.

The occasion goes through pretty well and now comes the first EMI and you wake up by the SMS on your mobile that Rs.7000 has been debited from your account on account of the Loan Payment amount. Now you realize that EMI is not actually Easy 🙂

The 3 alphabets E.M.I. become a nightmare for you. Now, starts the real game when that date comes when you keep getting the chills that you are paying huge sums as interest to the bank. Now, you decide that whenever you are going to get ample money, the first thing you will do is pay your loan.

Sooner or later, comes the great day when you have enough cash in hand with which you can easily get rid of that EMI.
BUT, to prepay the Loan or invest – that is a question most of us have when we have spare cash in hand. Here’s how to take that tough decision.

Let us take up an example here. Gagan bought a re-sale apartment three years back, for which he took a loan of Rs 5 lakh at 8.5 per cent. He pays a monthly installment (EMI) of Rs 5,000. Now, he wants to invest this money in his monthly saving rather than use it to prepay the loan; but is unsure. His monthly income is Rs 50,000.

Gagan could actually do the both – make a part pre-payment of the loan and invest too. Here’s how he can achieve this.

Pre-pay in installments:
Gagan can use a part of his savings in the prepayment of the loan thus, reducing the overall loan tenure which will help him in saving on the interest that he pays to the bank. Since, his loan amount is less troublesome as compared to his monthly income, he can part prepay at regular intervals.

The thumb rule is that loan EMIs should not exceed 30 per cent of monthly income.

In Gagan’s case, he is well within this limit. Here’s what he should do:

Step 1: Set aside 20 per cent of his income for home loan Pre-payment.
Step 2: Accumulate this amount (from Step 1) every three months and make a quarterly prepayment of the loan.
Step 3: Check in advance with the bank if any pre-payment charges are applicable. If yes, he should plan the pre-payment accordingly to avoid these redundant charges. For instance, some banks allow up to 25 per cent of pre-payment without any extra charges.

The only thing to be kept in mind here is that “the prepayment charge” should be considerably less compared to the interest saved otherwise he may end up paying even more to the bank.

Invest smartly:
As far as investing is concerned, he has two got options in his kitty: Equity and Debt. Based on his risk profile and time horizon, he has to make a choice as per his future requirements and fulfil his long term financial goals. For investments longer than 5 years, the best option for Gagan can be equity as investment in equity over a long term has hardly disappointed investors.

For any time frame below this period (less than 5 years), it is better to opt for Debt Instruments as the Equity Markets have generally proved volatile over a short period of time.

Must Read: 4 Golden Rules of Equity Investing

Equity mutual funds also make a great choice for investment when you do not have an in-depth knowledge about investing in Equity directly. But given the volatile nature of the market and the loss experienced by investors in the past months, Gagan should keep his expectations a bit towards the realistic scenario. He must be patient enough and willing to wait it out for at least 10 to 15 years to see an excellent return from equities.

On the debt side, bank deposits have gained more popularity lately, because of the surety that they give on the safety of your money. Nowadays, the concern for the investors has been on the Return of investment rather than Return on investments. So, if Gagan is looking for a safe avenue along with tax benefits, he could lock his money for a five-year term.

This is the case of one Gagan who was in dilemma whether he should pre-pay his loan or invest the same amount to gain more returns on the same amount.

Please add your views below about what one should do in such a scenario. There must be many more Gagans out there who may be benefited by your smart strategy to tackle this situation of dilemma.

{ 3 comments… read them below or add one }

Lanny Ollom March 30, 2010 at 4:42 am

There is nothing that can make me believe that loans have a good side to it. I have been up to my neck with loan debts and I have no way of repaying it. I wonder why there are loaning institutions since in the first place; they should be done away with.

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Amandeep Singh March 31, 2010 at 1:40 am

Thanks a lot for sharing your views but there are good sides to loans also 🙂

It totally depends on how you use the funds. Many children get the education on loans, small businesses rely totally on small loans to make it big, So there are different aspects also which make the loans important. 🙂

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Kumar May 29, 2012 at 4:13 pm

Good read…but I think otherwise….making a prepayment is dependent to the duration and time when prepayment is being made. If prepayment is made to a old loan then it is not much of an use as the interest component is already low provided borrower has paid EMI on time. In such a case bank has already got what it was looking for ‘interest’ :)…..second if u wait till u got 25% to prepay the loan again u r paying interest during waiting time and also u won’t invest such amount which u intent to use prepay.

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