Honour The Past Or Shape The Future?
An issue in the sphere of investing that is almost universally applicable to almost all individuals is the question as to whether it is better for those paying off any given form or multiple forms of debt to focus our monthly savings solely on paying off debt or run their investments in parallel to their debt servicing payments. This proves to be a tricky trade off since both options come with clear pros and cons that are both significant and impactful.Therefore any decision taken in this regard must come on the back of a clear plan drawn after adequate amounts of forethought.
In most cases we tend to make extreme decisions, either placing a disproportionate amount of emphasis on paying off debt or continuing to invest significant amounts even with a significant debt burden. But such approaches rarely prove to be optimal. Therefore, in today’s post I will highlight the considerations that need to be made before we decide whether to pay off debt or invest. I will also show whether either option is a clear winner relative to the other, or if both can be balanced as part of a clear financial plan.
The first factor to consider when deciding whether to pay off debt or invest is to look at the kind of debt we are dealing with, and whether our debts are putting our finances under severe stress. Any debt that is taken on can be reclassified as good debt or bad debt. Good debt represents low cost debt taken on to fund or purchase assets which would generate cash inflows in the future, therefore helping pay the debt back faster. Bad debt represents debt taken on at a high cost to fund personal consumption. Such debts do not create assets which can then be used to pay off the underlying debt as soon as possible. The differences between good and bad debt are summarised in the graphic that follows.
In almost all cases, good debt puts an individual's or a household's finances under relatively lesser stress as compared to bad debt. Therefore we need to analyse the list of our debts and see what portion of our debts can be classified as good and bad debt respectively. After that, we must focus on paying off debt if we find ourselves facing any or both of the following situations :
1. Our bad debts outnumber our good debts. For example, an individual has an outstanding car loan (bad debt), an outstanding personal loan (bad debt) and an outstanding education loan (good debt). This means that the individual has 2 bad debts and 1 good debt that need to be paid off.
2. The absolute total amount of our bad debts outweigh the total amount of our good debts. For example an individual has an outstanding home loan of Rs 4,00,000 (good debt), an outstanding education loan of Rs 1,00,000 (good debt) and an outstanding personal loan of Rs 6,00,000 (bad debt). In this case even though the number of good debts are more than the bad debts, the personal loan amounts to Rs 6,00,000, but the home loan and education loan total up to Rs 5,00,000 (4,00,000+1,00,000). Therefore the focus must be on eliminating the personal loan before the option of deploying savings towards investments can be considered. Those who find that they do not face either of the two situations discussed above can safely use any residual savings available after making their debt servicing payments to run their investments in parallel to their EMIs.
Apart from monthly savings, any unexpected income and/or windfalls we receive (for instance an annual bonus or a salary hike) are also a factor when deciding whether to service debt or invest. The key thing to consider here is the absolute amount of the extraordinary cash inflow that we receive. If any particular windfall that we receive equates to a significant portion of any of our outstanding debts (say 20% or more), the most prudent thing to do would be to simply deploy the amount towards servicing our debts. Otherwise, windfalls can be split between both of these options in any proportion as we deem fit. If we wish to prioritise servicing our debts, the lion's share of the windfall may be allocated towards that end. If not, the majority of our windfalls maybe channelled towards our investments.
Theoretically speaking, there is a case to be made for a disproportionate focus on investing in equities when we are facing a reasonable debt burden. For instance if the average interest rate on our debts is 8% and the equity markets have returned 12% on an average in the recent past, it might seem a good bet to put our money into the equity markets and use the 4% differential between prevailing equity returns and the average interest rate on our debts to rapidly. But in practicality, things usually turn out to be quite different. This is because returns from market linked investment assets, especially equities are highly volatile. Therefore there is no guarantee that a period of substantial returns for equities or any other market linked asset would sustain in the future. And when we are dependent on sustained returns from market linked assets to boost our efforts to service our debts for a number of years, we automatically put ourselves in a disadvantageous position. A reasonably long period of poor investment returns would be enough to scupper our efforts to pay off our debts rapidly, sometimes to the point where our ability to service our debts is thrown into doubt. This would ultimately put us under more financial pressure compared to the amount we started with. Therefore, looking to invest in equity to turn debt free as soon as possible is almost never a good idea for all practical purposes.
There is no standard answer to question with regard to making a decision whether to service debt or invest that can be implemented to produce universally optimal results. The answer to this question would actually vary based on the various criteria discussed above and the circumstances that are prevalent in our lives at a given point of time. Servicing our debts represents the actions we have undertaken in the past and contributes to helping us achieve freedom from debt, which is a major milestone on the path to financial independence and wellness. Our investments contribute to helping us create and augment a networth for ourselves and thus represent our efforts to shape our respective futures. So, both options have their respective positives.
Hence, the ideal option in most cases would be to try and strike a healthy balance between servicing our debts and continuing our investments in parallel. But yes, this is an exercise that we need to approach with the greatest amount of caution and prudence. Therefore extreme approaches such as focusing solely on one of the two would not be ideal. Also, highly risky measures such as investing in equity and other market linked assets in an effort to service our debts in the least amount of time possible should not be undertaken at any cost. Only then can we strike a balance between honouring the past and shaping the future.