Repay or Invest ?

Should savers prioritise debt repayment or fresh investments?

There's a typical question about an investment problem discussed frequently.

 One particular person has a housing loan on which he is paying interest at the rate of 10.50 per cent per annum. He's paying this monthly EMI comfortably out of his income without any problems. Now, he finds that he also has some cash accumulated which he can invest.

He would like to know which is the better option: should he repay some of his housing loan before schedule, or should he invest in an equity mutual fund for the long-term.

This is not an uncommon dilemma. In fact, one would guess that practically every salary earner who takes a housing loan faces it at some point. You take a loan at an EMI you can afford. Eventually, your income increases and now you find that can pay back more of the loan than you'd originally planned. If you were to ask this question of a financial planner, the chances are that he would tell you to repay the loan first.

That advice is based on what is almost a first principle of personal financial planning--clear your debts before you save. That principle is a sound one and should almost always be followed.

It is  'almost' always.

If the choice were between clearing expensive credit card debt and saving, then clearly, one should do that. The same probably holds for most consumer loans, including big ticket ones. And certainly, this principle is most relevant to people who try to borrow and invest.

However, there are some caveats to the standard advice. Long-term investments in an equity mutual fund with good track record can fetch higher returns than the interest that this saver is paying on his housing loan. SIP returns are high for long term periods.

This situation is true for everyone who is trying to save while holding a housing loan.

In fact, in the case of a housing loan, the effective trade-off is even more in favour of not repaying the loan early because of the tax breaks one gets on the interest paid.

Here is how the savings option can work out:

Invest 10%  of your Home Loan's EMI in an Equity mutual fund SIP, with good track record - ( Systematic Investment Plan, monthly installments).

All your home loan - principal and interest- can be  recovered with an additional profit  in 20 years.

Example:

Consider  a Home Loan of Rs.20 Lac for 20 Years with an annual interest rate of 10.50%.

EMI will be Rs. 19,968.

In 20 Years,  Rs. 47,92,930  is to be repaid.

(Interest: Rs.27,92,930;Principal: Rs.20 Lac.)

Simultaneously, along with the EMI payments,start an SIP for Rs  2000 ( 10 % of the EMI) for 20 Years in an equity mutual fund with good track record.

With 20.40% returns, Fund Value will be 67,18,375 after 20 years.

Thus you get back all your EMI payments  along with a  profit of Rs. 19,25,445.

The calculations are based on actual figures as per past records.

The facts :

1.SENSEX has given an average return 20.4% in the past 36 years from 1979 to 2015

2.UTI MNC Fund has given a CAGR (compounded annual growth rate) of 21.13 % in the past 15 years.

3.UTI Equity Fund has given a CAGR  of 24.90 % in the past 4 years.

4.UTI Midcap Fund has given a CAGR  of 32.07 % in the past 5 years.