We sometimes get sizable cash inflow as windfall gains or bonus for salaried employees. The first question arises in our mind whenever we have a big cash inflow is whether to invest that amount for future or pay off existing debt to reduce EMI burden. We always feel like being caught between the devil and the deep blue sea.
Paying off debt and investing for future, both are important financial aspects of life. Paying off debt will help to reduce EMI burden and therefore improve your cash flow condition, and investing for future is beneficial for obvious reasons. Any rational human being will think about getting rid of debt as soon as possible, being debt free leads to healthy financial life.
But not always. Two important things to consider is potential cost of your debt and expected earning from your investment.
Compare Earning Against Cost:
One of the most common approaches to tackling the question of debt repayment versus investment, is to compare the interest rate of your debt to the returns on your investments. In general, high-interest loans that exceed your investment earnings should be paid off first. Likewise, if you have low-interest debt, greater benefit might come from making the minimum payments and putting more money into your investment accounts. Let me put it this way. e.g. If you have an outstanding loan on which you are paying 15% interest and you have an option to invest in a product which has the potential to generate 15% return, which one is better? Paying off debt will ensure you saving of 15% while investment has the possibility of generating 15% or even lower or higher return. There is an element of uncertainty here. This is something that you have to decide as an individual.
Consider the Type of Debt:
All debt is not equal. The type of debt you have, can play a role in the decision as to whether to pay it off as soon as possible or put your money towards investments. High-interest loans that are not tax deductible, such as credit cards, car loans or personal loans, should be paid off as quickly as possible. Other type of loans like mortgage loan taken to buy house or education loan for which you get tax benefits are in fact good to carry on as typically they come with lower interest rates and real cost comes down even further after taking tax advantage into account. Typically, a 15 year home loan costs you around 9.5 to 10%, this rate further comes down after considering tax advantage on that.
Determine Your Goals:
Everyone's financial situation is unique so it only stands to reason that your personal financial intentions will play a part in your decision. For many people, being debt-free offers a sense of relief that can't be quantified. For others, having an emergency fund that will cover eight months of expenses helps them to sleep at night. Emotions can sometimes overrule logic when it comes to financial decisions.
Depends on Human Psychology:
Human psychology also plays an important role in financial decision making. Certain class of people who are typically risk takers prefer to continue with debt and like to utilize funds available for investment to generate better return, even if it comes with risk. e.g. entrepreneurs, businessmen. They will always love to put that money in their business or in an investment product, which has potential to generate return over and above the interest paid on outstanding debt.
Strike a Balance:
You can also choose to make part payment of outstanding loan and bring the EMI down, as most loans are charged on reducing balance basis. So if you make part payment of outstanding loan, your EMI can come down to that extent. The remaining amount you can use to make investment.
e.g. You have 2 lakh outstanding in car loan and you get 2 lakh as some cash inflow. Should you use entire 2 lakh to pay off outstanding loan. Rather you can use 50% of the amount to pay off debt and bring down you car loan EMI and remaining 1 lakh can be invested for future.
The Bottom Line
There is no 'one size fits all' solution to the question of whether it is more important to pay off debt or invest. Every individual has his/her unique financial situation, which needs to be considered before taking any decision. e.g. if you have not created any emergency funds, utilize available money to put aside in short term bank FD or money market mutual funds so that can be used anytime if emergency arises rather than paying off debt.
If you find it really confusing to decide, try tackling both at the same time by making part payment and part investment or put your focus on financial goal to gain peace of mind.