When people have surplus money, one question often comes up: should they invest it to build wealth or use it to repay an existing loan faster? While both options can strengthen one’s financial position, there isn’t a universal answer. The right choice depends on factors such as the type of loan, expected investment returns, financial goals, tax implications and personal circumstances.
According to Mayank Prakash, Co-Founder & Director, aarthiq, a broad way of thinking about this decision is by comparing the loan’s interest rate with what one might reasonably expect from investing on a post-tax basis. “Beyond that, factors like an emergency fund, job stability, remaining loan tenure and personal comfort with carrying debt could all play a role. Every situation may look a little different,” he added.
Compare post-tax returns, not just headline numbers
One of the biggest mistakes people make is comparing a loan’s interest rate with expected investment returns without accounting for taxes.
Loan rates and investment returns aren’t always measured in the same way, making a post-tax comparison more meaningful than relying on headline numbers alone. For instance, a home loan carrying an interest rate of around 8-8.5 per cent may be compared with long-term equity investments that have historically delivered returns in the 11-12 per cent range. However, after factoring in Long Term Capital Gains (LTCG) tax, the effective return could work out closer to 10-10.5 per cent. That gap may still be worth considering while deciding whether to invest or prepay a loan.
When repaying a loan first may make more sense
Paying off debt could be the better option when the borrowing cost itself is relatively high.
According to Mayank, this is particularly relevant for loans carrying interest rates of around 13-14 per cent, such as some personal loans. In such cases, the savings from prepaying the loan may appear more certain than market-linked investment returns, which can fluctuate depending on market conditions.
When continuing investments alongside EMIs could work better
There are also situations where investing while continuing regular EMI payments may help build greater long-term wealth.
He cites the example of someone with a home loan of around 8 per cent and a monthly surplus. Instead of directing that surplus towards loan prepayment, continuing a Systematic Investment Plan (SIP) for around 15 years could, based on long-term market trends, potentially grow into a noticeably larger corpus than the amount saved through prepayment over the same period. However, this would depend on actual market performance and cannot be guaranteed. Meanwhile, if you are looking to start SIP, here’s how the top 5 mutual funds performed over 5 years.
Does the type of loan matter?
The type of loan can significantly influence the decision.
According to experts, home loans generally carry relatively lower interest rates, making it worth exploring continued investments alongside EMIs. Personal loans, which usually come with higher borrowing costs, could warrant greater focus on repayment. Car loans, since they finance a depreciating asset, may require a different approach, while education loans could fall somewhere in between depending on an individual’s career stage and financial circumstances.
Tax benefits could influence your decision
Tax implications are another important consideration.
He notes that deductions available on home loan interest and principal may reduce the effective cost of borrowing for some taxpayers, depending on their tax bracket. Similarly, different investment instruments have different tax treatments, which influence the actual returns earned after tax. These factors could alter the comparison between investing and loan repayment, although the exact impact would vary based on individual income levels and the investment instrument involved.
Personal circumstances matter as much as the numbers
The decision isn’t driven by interest rates alone.
Mayank is of the view that age, financial goals, emergency savings and risk appetite are equally important.
“Younger individuals may have a longer investment horizon, making short-term market fluctuations less concerning, while those with near-term financial goals may prefer a more cautious approach,” he said.
He also suggests ensuring that an emergency fund is in place before aggressively investing or prepaying debt. Personal risk appetite can also lead two individuals with similar financial situations to make different decisions.
Common mistakes to avoid
• Comparing loan interest rates with pre-tax investment returns instead of post-tax returns.
• Not building an emergency financial cushion before investing more or prepaying debt.
• Treating all types of loans similarly without considering their borrowing costs.
• Prepaying a relatively low-cost loan while higher-cost debt remains outstanding elsewhere.
A simple checklist before deciding
Before deciding whether to invest more or repay a loan, Mayank recommends asking yourself a few questions:
• Is there an emergency fund already in place?
• How does the loan’s interest rate compare with expected post-tax investment returns?
• Does the loan offer any tax benefits?
• Is your income reasonably stable in the near term?
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