If you are paying off a personal loan and suddenly find yourself with an additional Rs 25,000 every month, you may be tempted to invest the money through a Systematic Investment Plan (SIP).
However, if you are carrying a high-interest personal loan, using that extra money to reduce your outstanding debt could be the more financially sensible choice.
The decision ultimately depends on the interest rate on your loan, your expected investment returns and your ability to handle market risk. Personal loans generally carry higher interest rates than secured loans, while returns from equity mutual funds are market-linked and are not guaranteed. Here is how to compare both options to make the right choice for your money.
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Why Paying Off A Personal Loan Can Make Sense
Guaranteed savings: When you make an additional payment towards a loan, you reduce the amount of interest you would otherwise pay to the lender. For instance, if your personal loan carries an interest rate of 14%, reducing the outstanding principal effectively saves you future interest at that rate.
High cost of borrowing: Personal loans are unsecured and can come with significantly higher interest rates than home loans. Keeping such debt for longer can increase the overall interest spending and keep your monthly cash flow tied up.
Financial flexibility: Clearing a high-cost loan faster can free up your EMI once the debt is repaid. The money can then be redirected towards investments, emergency savings or other financial goals.
When Can A SIP Be Considered?
A SIP may be worth considering when the loan carries a relatively low interest rate and you have a long investment horizon. Equity mutual funds have the potential to generate higher returns over the long term, but these returns are not guaranteed.
For example, suppose your home loan interest rate is 9% and you expect your equity mutual fund investment to generate around 12% over the long term. The expected investment return is higher than the borrowing cost, which could make investing attractive.
What About A Personal Loan?
The calculation changes when the debt is a personal loan with a much higher interest rate. If you are paying 14%, 16% or even more on the loan, an expected equity return of 10% to 12% may not justify taking the additional market risk.
In such a situation, using the additional Rs 25,000 to reduce the loan principal can provide a more certain financial benefit.
The Middle Ground: Split Your Rs 25,000
You do not necessarily have to choose between loan repayment and investing. One option is to put Rs 15,000 or Rs 20,000 towards additional loan repayments while investing the remaining Rs 5,000 to Rs 10,000 through a SIP.
This approach can help you reduce expensive debt while also maintaining an investing habit. However, before making any prepayment, review the terms of your loan agreement and check whether your lender has applicable prepayment or foreclosure charges.
Also Read: Rs 1 Lakh Credit Card Bill: What Happens If You Pay Only The Minimum Due?
What To Do After The Loan Is Cleared?
Once the personal loan is completely repaid, you can redirect the entire money that was going towards the EMI towards investments.
For example, if you were already paying an EMI of Rs 25,000 and were using another Rs 25,000 for prepayments, clearing the loan could eventually free up Rs 50,000 a month for investing, subject to your other financial commitments. But before investing aggressively, make sure you have an adequate emergency fund.
Eventually, prioritising repayment is generally the safer approach for a high-interest personal loan. SIPs can be considered alongside or after debt repayment, particularly when you have a long investment horizon and can tolerate market fluctuations.
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