When prepaying loan is optimal

Our investing and spending decisions require trade-offs. We typically weigh these trade-offs but often arrive at a decision based on our emotions. In this article, we discuss one such trade-off you may face. If you just received an unexpected amount of cashflow either from an inheritance or from a long-forgotten claim, what will you do: Invest the money or prepay your existing loan?

For most, the sooner they pay off a loan, the less anxious they feel. If you are one of them, then it is emotionally optimal to prepay the loan. For others, a simple back-of-the-envelope calculation is useful. This involves comparing the expected investment returns with interest saved by prepaying the loan. Suppose you invest the cash flow in a fund with expected post-tax returns of 10%. If the interest rate on the loan is 9%, then you should invest the amount and continue paying your loan as per the original schedule. This is because the investment return is greater than the interest rate paid on the loan. Also, if this loan is towards your self-occupied house, you are building equity in the property as you repay your loan, in addition to investing the unexpected cash flow. Some who are risk-takers may even choose to invest the cash flow in derivatives to increase returns.

The above argument does not consider income variability. What if your current employment is an industry that has seen massive disruptions because of AI? If you feel anxious about your future income, are you comfortable carrying a loan? If not, it may be better to prepay the loan. Note that if you are concerned about your future income, it is highly unlikely that you will invest aggressively. That means you are more likely to lean towards bonds than equity; the expected returns on the investments are likely to be lower than the interest rate on the loan.

The decision between prepaying a loan and investing the cash is one of the many trade-offs we must make. Other trade-offs include buying a house or renting one for self-occupation. If all these decisions are based on simple economics, life would be easier. Unfortunately, we often yield to our emotions which can bias our decisions. So, what is optimal from an emotional perspective may not always be economically meaningful. But emotions are important for a holistic financial wellbeing. Therefore, prepaying a loan with unexpected cash may be optimal.

(The author offers training programmes for individuals to manage their personal investments)