Pre pay the Loan :

Prepay of a loan refers to making a payment on the loan before the scheduled due date or before the loan term is completed. This can be done in part or in full(pre closure). Making a prepayment can help borrowers reduce the total interest paid over the life of the loan and can also help them pay off the loan faster. Some loans may have prepayment penalties, so it's important to check the terms of the loan agreement before making any prepayments.

Prepay the loan vs Invest in Equity

Let's say you have received a gift, bonus, variable pay and you want to decide between pre-paying/pre-closing a loan and investing the money in equity (riskier asset) depends on various factors such as the interest rate on the loan, the potential return on investment, your risk tolerance, and your financial goals. Here are some considerations to help you make a decision:

Emotional Decision:

If the loan burden is excessively high and causing financial strain, the amount received can be used to reduce the loan to a more manageable level. This can alleviate a significant amount of stress. While this may not always be the optimal use of funds.

Mathematical Decision:

1. Interest Rate on the Loan: If the interest rate on your loan is higher, it may be more beneficial to prepay loan. By paying off the loan early, you can save money on interest payments. Usually unsecured loans like Personal Loans will have higher interest rates (>10% interest rate).
2. Return on Investment: Consider the potential return on investment if you were to invest the money instead of using it to pre-close the loan. If you expect to earn a higher return on your investments than the interest rate on the loan, it may be more advantageous to invest the money ( also called Debt Leverage)
3. Risk Tolerance: Investing in the financial markets carries a certain level of risk. If you are risk-averse and prefer the certainty of paying off your loan, pre-closing the loan may be the better option for you.

Ultimately, the decision to pre-close a loan or invest the money depends on your individual financial situation and goals. It may be beneficial to consult with a financial advisor to help you make an informed decision based on your specific circumstances.

Suggestion : 

Nifty 50 index Mutual Fund has given around 12% CAGR (10 years), if you have some risk appetite and can with stand market fluctuations. It is better to invest the pre-pay a secured loan (Home Loan, Car Loan, Gold Loan) where the interest rates are less than 9%. Again it depends on individual's risk appetite. I would suggest you to clear off unsecured loan having higher interest rates.

#WalkTheTalk. I have car loan outstanding of ~Rs. 4 Lakhs with interest rate of 8.5%. Instead of pre paying the loan, I invested in Nifty50 & Large cap funds which historically given 12% CAGR.

Thanks,

Honvest Team.