Before you start investing, get rid of your debt
One may wonder as to how is debt related to investments. Actually there is a very subtle relationship. Most investors do not invest in lump-sum and they prefer to invest via systematic investment plans (SIP). That is because these SIPs give the benefit of rupee cost averaging and also give the added benefit of syncing with your sources of income flows. When you have too much of debt on your balance sheet, then your EMIs remain an overhang on your finances. Hence you are not able to commit yourself to regular investments in equities towards meeting your long term goals.
In the famous Shakespearean play, Hamlet, Polonius advises his son Laertes, “Neither a borrower nor a lender be; for loan oft loses itself and friend and borrowing dulls the edge of husbandry”. Be it households, businesses or economies; it is debt that normally takes these units to the brink of bankruptcy. Borrowings are part of our balance sheet and we borrow for buying a house or a car. But the problem is with reckless borrowing or high cost borrowing. If you are still paying 35% interest on your credit card or 20% on your personal loan then it is highly likely that you will create serious wealth issues. Your journey has to begin with reducing your debt so as to make your investing activity more meaningful and fruitful. One of the best ways of gradually reducing your debt and adding more power to your investments is through a process called laddering.
How laddering helps manage debt and enhance investment capability
Laddering is essentially about prioritization. For example, you pay interest rate of nearly 3% per month on a credit and when annualized the costs are as high as 40%. If you have a fixed corpus with you, what should you do? You can earn 9% on debt funds, 12% on balanced funds or 14% on equity funds. Rather, if you use the funds to repay and close out your credit card, you save nearly 40% cost per annum. That is almost akin to an investment that yields 40% return per annum. That is why; when you start off on your financial plan and investment allocation, first have a plan to get out of debt and then think about growing wealth.
But how do you go about laddering? There are some loans that are large in size and some that are linked to assets. Then there are loans like home loans and education loans which give you tax benefits on the interest paid. How do you prioritize and take a call in these circumstances. Here is the pecking order of laddering you must follow.
Start by reducing your credit card outstanding first…
A credit card costs you around 40% per annum so when you close your credit card you are effectively earning 40% annually. More importantly, you have a more certain corpus that you can fall back upon to plan your future investments. Paying 3% interest a month is hardly a smart way to manage your finances. Once you close your credit card outstanding, you not only save that outflow but you can invest your monies with lesser overhang of uncertainty.
Then target your personal loans…
Personal loans can be a stop gap arrangement but most people tend to use it for the full tenure. You can avoid that since these are fairly high cost loans. Personal loans cost between 16-18% and if you add up the other costs, they can go to 20%. Once your credit card dues are taken care of, the next step in the debt ladder is personal loans. You save the 20% interest cost and the EMI can now become a good EMI or a SIP investment. Don’t worry about exit loads as you can negotiate with your bank which is hungry for prompt repayments. Even assuming that you pay the exit load, you are better off without the loan.
You can look to tweak your home loan too; and why not?
Should you close a home loan if you have the liquidity? Interest on home loans gives you tax exemption under Section 24 of the Income Tax Act up to Rs.2 lakhs and the principal is also exempt under Section 80C. There are two things to watch out here. Firstly, there is no guarantee that the apartment you buy will appreciate in value, like it was 10-15 years back. Negative equity is a real threat to home loans. Secondly, apartments don’t come cheap. Your exemption limit of Rs.2 lakh is hardly enough to buy a 2 BHK apartment in smaller towns. Instead of paying EMIs that don’t give tax exemption you can repay what is not tax efficient and reduce your outflows. These can be directed towards your investments.
Debt can be a double edged sword in most cases. The quicker you get out of high cost debt, the better it is for a smooth investment journey.