04 Feb 2019 06:51am IST
Neetant D Sinai Shirodkar
Whether it's a secured loan, personal loans, credit cards or all of the above, more and more people are drowning under the burden of their debt, and for those with enough income to keep their heads above water, the only logical choice may seem to be paying off their debts as quickly as possible. But wait is that really the best financial game plan? While it certainly feels good to be debt free, in some extremely rare situations you may be better off simply maintaining your debts (ie paying the minimum payments on your loan) and investing your spare cash.
Learning the difference between ‘Good’ Debt and ‘Bad’ Debt:
Begin by making a list of all your loans and list everything that you bought with the borrowed money. All of your debts will fall into one of two categories: good debt or bad debt. That's based on the following criteria. If the purchase involves something that typically increases in value over time, then it's good debt. For example your home loan, your education loan etc. You accumulate bad debt when you use credit cards or other loans to establish or maintain a lifestyle you could not otherwise afford. Purchases that you no longer remember or use, such as entertainment, travel, or basic living expenses, are examples of bad debt and living beyond your means. Going into loan to purchase a new car is also a bad debt, since its value quickly depreciates and the interest rates it carries are very steep.
Deciding whether to invest or pay off debt
Once the task of identifying the loans is done, eliminate all of your bad debt before you invest. The reason that you should eliminate your bad debt before you start investing is simple: you have a double expense associated with bad debt.The purchases made with bad debt include items that go down in value over time, so you're losing money as those items depreciate in value.Secondly the purchases made with bad debt may have a high interest rate associated with them, so you're losing money by paying an interest expense. For example, in the case of credit card usage, that expense can be quite high.
Invest once you only have good debt
If all the loans you have is good debt, you can invest because you'll typically see an appreciation in value of the things you purchased with the liability. If you purchased a house, that house will usually increase in value over the long term (though this is not guaranteed). That increase in value will offset, to some degree, the interest that you're paying for the loan. Add to it the tax benefit one enjoys over both the principal as well as the interest payment.
With education loans, you invested in your professional career. Your salary should increase over time as you gain more experience and/or get promoted.
While it is certainly a big relief to be loan free, it should be noted that by not investing for almost 10-15 years (rough estimate of loan pay-back period), you will be missing out on the benefits of compounding which would have created an unexpectedly big corpus over the years. The big problem with clearing off all your loans and then starting to invest is that you may not be able to gather enough assets to retire. Conversely, if you’re too aggressive, you may end up losing everything in your investments, while still servicing your high cost loans.
Give yourself some time, evaluate your exact situation and then take the best decision.