Understanding the idea of loan prepayment with SIPs Systematic investment plan, or SIP, allows you to invest a specified amount from time to time in mutual funds. Not many borrowers choose to have an SIP in conjunction with their loan repayment, with the expectation of recovering the investments at a later date to prepay part-loans or prepay the loan ahead of time. The rationale is that mutual funds will yield more returns than the cost of borrowing through the loan and thus seem to be a smarter choice.
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Comparing SIP return with loan interest The success of this strategy is based on the comparison of SIP return and your loan interest rate. The majority of personal loans carry an interest rate of 12% to 20%. Equity mutual funds in which SIPs usually invest promise higher returns but at some cost. Your SIP in a rising market may grow large enough to repay the loan in advance. But when markets perform poorly, you could end up with less cash than anticipated, and the high interest on the loan keeps piling up.
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Risk of market volatility Unlike fixed and definite EMIs of loans, returns on SIP investments will be influenced by market fluctuations. A prolonged downturn can decrease the corpus you planned to use to prepay the loan. Uncertainty creeps into what otherwise would be a simple financial agenda — paying off debt. If you have taken a high-interest loan, it is not advisable to rely on unpredictable returns since the cost of interest could outweigh the benefit in terms of investment income.
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Opportunity cost of prepayment On the other hand, prepayment through SIPs is financially worthwhile at times. If your loan rate is typical, and your SIP always returns you better rates in the long run, you might benefit from keeping the loan afloat while building wealth. This calculation of opportunity cost varies for each borrower depending on risk tolerance, time period, and margin between loan rate and investment return expectation.
A judicious mix between debt repayment and investing The most sensible approach at times is a combination of debt repayment and investing. Pre-paying expensive loans mid-way and concurrently continuing with SIPs for longer-term goals can reduce your cost of capital without completely avoiding wealth generation. Financial experts often recommend paying off expensive debt first and then aggressively pursuing SIPs thereafter.
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Why personal situations count Finally, it will depend on personal circumstances. Someone with a stable income and a very long investment horizon may be comfortable using SIPs to form a prepayment corpus, but someone else with very tight cash flows may be in favour of direct repayment of the loan because that will avoid the worry of market risk. It is essential to understand your individual financial objectives and risk tolerance before using this strategy.
