Invest Or Repay? : Answering A Million Dollar Question

An issue that faces almost all individuals with one or more outstanding debts is : Invest for the future or repay outstanding debts? This proves to be a tricky trade off. Both options come with pros and cons that are significant and pervasive. In most cases we tend to make extreme decisions, placing a disproportionate amount of emphasis on either repaying or investing. But such approaches rarely prove to be optimal. Therefore any decision taken in this regard must come after adequate forethought. Therefore, today I will highlight the factors to be considered before making this decision. I will also show whether either option is a clear winner relative to the other.

Nature Of Debt

The first factor to consider the kind of debts we are dealing with. Any debt we taken on can be classified as good debt or bad debt. Good debts low cost debts taken on to fund or purchase assets. Such assets should generate cash inflows in the future. This would help repay the debt sooner. Good debts may also allow us to make use of another asset. Bad debts represent high cost debt availed to fund personal consumption. They do not generate cash inflows or allow usage of other assets. Home loans and education loans are prime examples of good debts. Personal loans and credit card debts are prime examples of bad debts.

Debt Composition

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 40,00,000 (good debt), an outstanding education loan of Rs 10,00,000 (good debt) and an outstanding personal loan of Rs 60,00,000 (bad debt). In this case even though the number of good debts are more than the bad debts, the personal loan amounts to Rs 60,00,000 but the home loan and education loan total up to Rs 5,00,000 (40,00,000+10,00,000).

Therefore the focus must be on eliminating the personal loan before the option of deploying savings towards investments can be considered. Those do not face either of these two situations can safely use residual savings available after paying EMIs to run their investments in parallel to their EMIs.

The Role Of Windfall Income

Any windfalls we receive (for instance an annual bonus or an inheritance) also impact this decision when deciding whether to repay or invest. The key thing to consider here is the absolute amount received. If any particular windfall equates to a significant portion of any of our outstanding debts (say 20% or more), we may simply deploy the amount to pay off debts. Otherwise, windfalls can be split between debt payments and investments in any proportion 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.

The Dangers Of Using Equity To Kill Our Debts

In theory, there is a case to be made for focusing on investing in equities with a reasonable debt burden. Say for instance that the average interest rate on our debts is 8% and the equity markets have returned 12% in the recent past. It would seem a good bet to put our money into the equity markets. The 4% differential between equity returns and the interest rate can be used to pay off our debts rapidly. But in reality, things are quite different. This is because returns from market linked 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 be sustained. So we would automatically put ourselves in a disadvantageous position.

A reasonably long period of poor investment returns is enough to derail our efforts to pay off our debts rapidly. It can even get to a point where our ability to pay EMIs is thrown into doubt. This would ultimately put us under more financial pressure than we started with. Therefore, turning to equity kill our debts in a flash is almost always impractical.

Invest Or Repay? : The Million Dollar Answer

The million dollar answer to this question is that there isn't a clear one. The answer actually depends on the various criteria discussed above and the prevailing circumstances in our lives. Servicing our debts helps make us debt free. This is a major milestone on the path to financial wellness. Our investments help us create and augment a networth for ourselves. They 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 strike a healthy balance between the two. But this balance must be achieved through caution and prudence. Therefore extreme approaches such as focusing solely on one of the two would not be ideal. Repaying existing debts and investing for tomorrow must both be given due importance. This would ensure that we don’t risk our present to shape our future.