You wouldn’t want to find yourself in a situation where you are struggling with debt. As discussed in many of our earlier posts, there are only 4 ways to get out of debt problems.
- Increase income
- Reduce expenses
- Reduce debt
- Reduce the cost of debt
- Or a Mix of all the above approaches
In this post, let’s touch upon the ‘Reduce Debt’ part. You can reduce debt by making a prepayment or expediting repayments so that the principal outstanding goes down quickly. You may have some investments. What role can your investments play to get you out of this problem or prevent this problem from aggravating? Clearly, you can sell some of these investments to get you out of debt trouble. In this context, let’s look at some of the self-goals that you must avoid.
Let’s begin with an example. You have stock or equity mutual fund investments of Rs 20 lacs. You have fixed deposits of Rs 12 lacs. And you have been making minimum payments on your credit card. Your credit card debt outstanding is Rs 8 lacs.
This is nonsense. You are paying almost 40-45% p.a. on your credit card balance. No matter how confident you are of your trading and investment skills, you are extremely unlikely to earn this level of return on your equity investments. The odds are heavily stacked against you. You will most likely come out a loser in this entire loan and investment structure. Your FD interest rate won’t be higher than cost of credit card debt or a personal loan interest rate. It is better to liquidate such assets and pay off the loan you are struggling with.
Here are a few things you must consider when making a choice between making the loan repayment or investing:
- If the post-tax return on your investment is higher than the post-tax cost of your loan, you make (or continue with the) the investment or else you make the loan repayment (or liquidate the investment to repay the loan). Often, the cost of loan will be higher. For some loans where repayment is eligible for tax benefits (say education loan or home loan), you can route the excess funds towards investments or continue with the investments.
- The loan interest rate is guaranteed. Returns on your investments are not. You must pay 10-15% p.a. on your loan. In good years, you may be able to earn higher returns. However, there is no guarantee that you will be able to do that. What if your portfolio loses 15% the very same year? Retaining investments and not repaying the loan will look like a very bad decision. Won’t it?
- Though not exactly related to the topic, keeping the above two points in mind may also help you avoid unnecessary debt and potential debt troubles in the future. For instance, we now understand that it is not a good idea to take loans against volatile investments. Taking loans against equity investments (or to make equity investments.) is cavalier, not smart. There are loan products that grant you loan against your debt fund investments or fixed deposits. Again, it is very unlikely that the post-tax return of debt mutual funds or fixed deposits will be higher the cost of your personal loans or credit card debt. Simply sell such investments to use for your requirements and not take a loan against this very investment.
There are some investments that have very long lock-in periods or where very heavy penalties are very high. Ones that come to mind are PPF and traditional life insurance policies. In such cases, you can use the interesting relaxations in the product structures to your advantage. PPF has a lock-in of 15 years but allows loan facility from 3rd till the end of 6th year. From the 7th year, partial withdrawals are allowed. Traditional life insurance plans allow you to take out loans from the third year. Explore these cashflow avenues.
A Few Important Caveats
I understand that there may be tax issues or exit penalties that may be holding you back from selling the investments. However, barring a few extreme cases, selling the investment will be a better objective choice. In some cases, you may have earmarked an investment for emergencies or for an imminent expense. In such cases, you can consider not selling since you may have to take out another high cost loan to meet such expenses. Selling won’t help in such cases. The key is to make an objective assessment and not an emotional one.
Some of your investments may be for your long term goals such as retirement. If you have to keep accessing these investments time and again to square off the loans, your long term goals may be compromised. If you have to do this frequently, you have to change something very fundamental with your lifestyle.
If the value of the asset is quite large as compared to the quantum of loan and there are significant transactions and tax costs involved, it may be prudent not to sell that specific asset to close the loan. For instance, if you own a property whose expected market value is about Rs 1.5 crores and the credit card debt that is troubling you is about Rs 3 lacs, then you may want to hold back the sale of property to square off the loan. A property sale takes a lot of time to execute. If you incur a transaction costs of say Rs 2 lacs and capital gains tax of Rs 10 lacs, property sale is a very expensive option. You have to figure out other options. By the way, if the only asset that you can sell to get rid of the debt trouble of Rs 3 lacs is a Rs 1.5 crore property, you have seriously messed up your financial planning. Seek professional assistance.