Got a pay raise? Have extra ₹20,000 every month? But how to decide what to do with the money: repay your personal loan faster or start investing it through a mutual fund SIP?
Let’s crunch some numbers first to check which saves you more money
Let’s assume you have a ₹5 lakh at 14% interest for three years. The monthly EMI works out to roughly ₹17,100. If you continue paying only the EMI, you would pay about ₹1.15 lakh in interest over the full tenure.
Now, after you get a raise, you suddenly have an additional ₹20,000 every month, and with that you can:
Use ₹20,000 to repay the loan
That way, instead of paying ₹17,100, you pay around ₹37,100 a month towards the loan. That way, the ₹5 lakh loan could be cleared in about 15 months. So now, you pay roughly ₹47,000 in interest and save nearly ₹68,000 compared with sticking to the original repayment schedule.
There is another advantage. Once the loan is cleared, you are free of EMI and can redirect the entire ₹37,100 per month towards investments.
Invest ₹20,000 through an SIP
Suppose you continue paying the ₹17,100 EMI and invest the additional ₹20,000 every month in an SIP.
If the SIP earns an assumed 12% annualised return, ₹20,000 invested every month for three years could grow to roughly ₹8.62 lakh, against total investments of ₹7.2 lakh.
Obviously, this looks attractive. But if you dig deeper, the bigger picture unfolds.
What happens over five years?
If you first clear the loan in about 15 months and then invest the full ₹37,100 every month for the remaining 45 months, the corpus will be nearly ₹20.95 lakh after five years at a12% annual return.
In contrast, investing only ₹20,000 every month for the entire five years would create a corpus of about ₹16.33 lakh.
(12% return is only an assumption, while the 14% loan cost is contractual.)
So, for a high-interest personal loan, clearing the debt first can be the more effective and financially sensible choice. Once the loan is paid off, the freed-up can be redirected to investments.
The decision can change if the personal loan rate is relatively low, or if the investment horizon is very long. Borrowers should also check whether their lender charges any prepayment or foreclosure fee before making extra payments.