The million dollar investment question – To go for loan pre-payment or the investment with attractive returns

Most of us at some point of time wonder what to do with that surplus amount that we may have got in our savings. Whether to pre-pay the ongoing loan or to go for that investment with attractive interest rates is the question that plagues most of us. Let us attempt to find the answer to this million dollar question for the benefit of humanity!

Let us take a hypothetical case of a $1mn loan at 7% interest rate for 20 yrs. For simplicity let us say the loan has just been taken, rate remaining flat and exclude any other variables. If we look at the loan amortisation schedule, the total amount that will be paid by the person taking the loan will be around $1.8607 mn. Now say the person who availed the loan ends up with a surplus of $100000 after he availed the loan. Let us say this is the surplus after setting aside the next few EMI amounts for repayment. The question in his/her mind would be should I invest this amount in the attractive scheme or stock that showed online or should it be used to pre-pay the loan.

Let us look at both the situations. If one decides to pre-pay the loan, what will be the outcome. And if one decides to invest in that promising investment scheme that offers 10% return after 5 yrs investment period. In the first case, if one pre-pays $100000, as per the updated loan amortisation schedule, the total amount that will be repaid at the end of 20 yrs will be $1.6089 mn. Now let us look at what would have happened if one had invested instead of pre-payment. In this case, let us assume no other pre-payment was done in the 5 yr period and EMIs were paid regularly. So at the end of 5 yrs, the investment done would yield an 10% compounded amount of $161050. Now if at end of 5 yrs, if one pre-pays the loan using the proceeds of these investment, the updated amortisation schedule will show that the total amount repaid at the end of 20 yrs would be $1.6285 mn. So a clear saving of $1.6285 mn – $1.6089 mn=$1960 if one pre-paid the loan!

Now considering you may have to pay taxes on the investment, there may be charges and if the investment is market linked, then conaidering the fluctuations, you may end up with say a less than expected 8% net return on your investment. In that case the compounded return that you would have got on the attractive investment after 5 yrs would be $146932. If one invests this proceeds in loan prepayment after 5 yrs, then the revised loan amortisation schedule would show a total of $1.6446 mn to be paid in 20 yrs. In such case pre-paying the loan instead of investing for 5 yrs at 8% would save you $1.6446 mn – $1.6089 mn = $3570 !

Now if the pre-payments continue as and when the surplus becomes available over the term of the loan, then this saving would be even more! So the next time you have to make a early pre-payment or investment decision, you know what to do depending on how much returns you expect in reality post all deductions. And if you are the one who likes to know the figures before you decide, just open that loan amortisation worksheet or calculator and get cracking at it for more savings !

*This is an advisory article and and the author take no responsibility for any outcomes basis the same. If you are in doubt or there are other considerations or variables in your case, please seek expert opinion before making your financial decisions.