What should be your investment strategy when in debt?

While managing your personal finance, you may face a dilemma of giving appropriate weightage to either investment or debt since both are important aspects of your personal finance. If you ignore debt repayment, then compounding interest will quickly spiral out and you may easily get into financial distress. If you ignore investment, then you may fail to accomplish many of your financial objectives. So, it is important to maintain the right balance between debt and investment.

Now, when you are already in debt, should you still invest money or wait till your existing debt becomes zero?

To invest or avoid while in debt

Certain important factors like interest rate can help you decide on whether to invest or pay the debt first. If the existing and expected interest rate on debt is substantially lower as compared to the interest or return you expect to earn from an investment, then you should prefer to invest over prepaying. For example, prevailing interest rate on a home loan is around 8.5 percent p.a. and you have earned extra income through annual bonus. You have the option to prepay the loan or to invest the bonus in a balanced fund, which is expected to give a return of 12 percent p.a. (assumed) after tax. In this case you, should continue to pay home loan EMI and use the fund for investing in a balanced fund to earn a better return. Beware of risk while investing money in a mutual fund.

If the interest rate on loan is close to or higher than the expected return from investment, then use your extra income to first clear the outstanding debt and thereafter use the remaining fund (if any) for investment in appropriate instrument.

Another important factor that you must check before using the income to pay debt or invest is to assess your prevailing liquidity situation. If you find it difficult to manage your regular monthly expenses after paying the EMI, then using the surplus income for repaying such debt could help you to reduce the financial burden.

Repaying the debt on time is very crucial for maintaining a good credit score. If you have surplus fund and you invest it, then do assess whether you will be able to liquidate it at the time of emergency without any capital loss. If yes, then you can think of investing money over prepaying the loan amount. For example, if you face financial emergency, such as job loss or an accident, and you don’t have enough money to repay existing debt EMI, then you can use this investment for emergency cash flow. However, if you are not sure about retaining the value of investing funds and its liquidity factor, then it is better to avoid such investment.

If you are planning to take a loan for other big ticket purchases, then instead of using the surplus income to repay your existing loan, you can use it to invest in appropriate instrument and later on use it to pay for your buying. For example, you are planning to buy a car after three months and you got a surplus income of Rs 5 lakh. You have an existing home loan with Rs 20 lakh outstanding and remaining tenure of 15 years, with an interest rate at 8.8 percent per year. Instead of using the surplus income to repay your home loan and taking a car loan to buy a new vehicle, you should invest it in a liquid fund for three months. The invested money can come handy later on for your car buying.

It’s important to maintain a balance between risk and reward

To make a correct decision you should focus on maintaining a fine balance between risk and reward while selecting one of the options. You must analyse the impact of your decision on your retirement goal and your other financial objectives. Try to cut down the risk associated with your debt by utilising the reward you expect to get by investing the fund.