Paying off a loan early may seem like the smartest way to become debt-free. But is it always the best financial decision? Some people, instead of repaying the loan early, use that money into investments. Depending on the interest rate, investment returns and your financial goals, this approach could help you build greater wealth over time.
The key lies in understanding the balance between reducing debt and growing your savings. But does math support this method?
Assumptions:
You decide to buy a vehicle worth Rs 12 lakh. You want a Rs 6 lakh loan for three years. However, you consider a Rs 8 lakh loan for five years and decide the Rs 2 lakh saved upfront should be invested. Here's how much returns you would need:
For this, we assume investments to Gold ETFs and equity mutual funds. Gold has historically given 10% annual returns. You can also choose equity mutual funds, which have potentially higher returns but are generally riskier.
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Step 1: Assuming the loans cost 7.5% interest per year for 5 years.
Loan A: Rs 6L, 3 yrs | Loan B: Rs 8L, 5 yrs | |
EMI | Rs 18,663 | Rs 16,030 |
Total repaid | Rs 6,71,870 | Rs 9,61,800 |
Interest | Rs 71,870 | Rs 1,61,800 |
Under Loan A you also pay Rs 2 lakh from your pocket, and save on interest. In loan B, you pay Rs 89,930 more interest. This means that over 5 years, your investment would need to generate this gap value at minimum for it to make sense.
How Much You Can Invest?
With loan B option, you can invest Rs 2 lakh saved upfront into Gold ETFs or equity funds.
Gold ETF Estimated Returns
Investment amount: Rs 2,00,000
Investment duration: 5 years
Expected rate of return: 10%
Estimated returns: Rs 1,22,100
Total value: Rs 3,22,100
Tax on gold ETF gains (at 12.5% without indexation): Rs 15,260
Final profit on Gold ETFs: Rs 1,22,100 - Rs 15, 260 = Rs 1,06,840
Additional gains: Profit on Gold ETF - extra interest paid = Rs 1,06,840 - Rs 89,930 = Rs 16,910
Investments in equity mutual funds:
Investment amount: Rs 2,00,000
Investment duration: 5 year
Expected rate of return: 12%
Estimated returns: Rs 1,52,468
Total value: Rs 3,52,468
With equity mutual funds, there is an advantage of tax exemption up to Rs 1.25 lakh on holdings above 12 months. This means that out of Rs 1,52,468 returns, only Rs 27,468 is taxable at 12.5%.
Tax on mutual fund gains
12.5% x 27,468 = Rs 3,433
Effective profit from mutual funds: Rs 1,52,468 - Rs 3,433 = Rs 1,49,035
Overall, gains over extra interest on loan = Rs 1.49 lakh - Rs 89,930 = Rs 59,070 (estimated)
This shows that with gold ETFs, you will be able to beat the additional interest paid over five years with potential gains of nearly Rs 17,000. However, with equity mutual funds, the additional gains are significantly higher at nearly Rs 59,000.
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Still, as a borrower, you need to be aware that the loan's 7.5% cost is certain. ETFs and mutual fund returns are never guaranteed and five years is a relatively smaller, riskier window to assume it will be a smooth journey. As a result, you need to be careful about such decisions and consult an expert before making any long term financial commitment to avoid any stress later.
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