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What should you do with windfall gratuity gains: Invest or pay off loans?

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With uncertainty looming large over jobs and pay cuts disrupting harmonious monthly household budgets, there is always a question of whether to continue funding retirement savings or clear off debt first.

A debt-free living mostly affords more opportunities and possibilities, but then there is also the temptation to leverage low interest rates during such times to build assets.

Where does one draw the fine line and how should one go about making financial decisions that we are happy about in the long run?

Prioritising paying off debt as opposed to saving for retirement depends on several factors such as: debt to income (DTI) ratio, current retirement savings, and types of loans taken.

“DTI ratio is defined as total monthly debt payments divided by gross monthly income. If an individual has a DTI ratio of 20 per cent or less, h/she is considered financially stable and can choose to reserve gratuity money towards retirement. The central banks define a DTI ratio of 40 per cent or more in a situation of financial distress, in which case the employee is obligated to use his/her gratuity money towards paying off loans. If a decision is made otherwise, the persisting DTI of 40 per cent may hinder his/her ability to take any further loans,” said Vijay Valecha, Chief Investment Officer (CIO), Century Financial.

The age of an individual coupled with current retirement savings is also a vital factor influencing the decision to pay off loans or not. “A younger individual may choose to continue accumulating debt since he/she has higher human capital left to pay off debts in the future and would like to get the ball rolling on having some savings. Whereas an older employee should work towards disposing leverage to live stress free in the future,” added Valecha.

Another important factor to consider is the type of debt and interest rate charged on it. “Pay off the most expensive debt first — rather than trying to reduce the number of loans. Also, check the cost of early payment. Know if there are any penalties associated with early foreclosure, so that the total cost is correctly measured,” said Vishal Dhawan, a certified financial planner and Chief Executive Officer (CEO) of Plan Ahead.

So, what kind of a loan must be paid off first?

Credit card debt must always be cleared first, especially if you are simply paying the minimum amount every month. An outstanding of Dh10,000 can take more than a decade to clear off the loan and you will end up paying the bank or the financial institution about 2.7 times more than the original sum.

Secondly, don’t look at closing smaller loans first and keeping the big one. An honest assessment of which loan to keep should be based on the interest rate being charged. “One should be paying off their credit card dues and personal loans first. Secured loans such as home loans and vehicle loans can wait. While prepaying a loan, individuals often overlook the costs associated with it such as foreclosure fees. It may be tempting to close a high interest personal loan due to a sudden inflow of cash but the early settlement charges that will apply must be accounted for before taking such decisions. If cash flows permit, borrowers should try to part prepay or foreclose high-cost unsecured loans. Secured loans, especially home loans can be paid in EMI (equated monthly installment) in the long run as they are generally low-cost loans,” said Valecha.

Come to think of it, taking a debt is not always a bad move

Its usefulness depends on the benefits you accrue from it. “Whether it is borrowing for a college degree, buying a home, or a car, the final determinant of whether the debt you are piling is good or bad is based on the question: Will this debt pay me back more than what I put in? A simple rule is that if the loan increases your net worth or has future value, it is good debt. If it does not and you do not have cash to pay for it, it’s bad debt,” said Valecha.

The king of all debt is a mortgage

“Investors must be wise and mortgage a property that is likely to appreciate in value every year. For instance, if you buy a house for Dh2 million, it appreciates by 4 per cent every year, the house will be worth Dh4.38 million when your 20-year mortgage is paid off (more than double the investment made). That is quality debt. Along with home loans, student loans are also considered good debt as it improves one’s ability to bag a well-paying career in the future,” he added.

Conversely, automobile and payday loans and credit card debt are constituents of bad debt. Plastic debt can ruin financial health and the interest rates are killer.

Moreover, the hidden fee is present in card loans, which naïve investors are unaware of. Automobile loans may not have the highest interest rate, but the value of the vehicle depreciates quickly and is thus considered as a bad debt unless the vehicle is a necessity and not luxury.

The bottom line is, if an investor is still a mile away from retirement and has low interest rate debt to pay off, he or she may choose to park his/her money towards a monthly systematic investment plan (SIP) in equity markets so that high returns are generated. The idea is to exploit the time value of longer-term investments along with the ability to take risks while h/she can afford to.

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