Do I Use My Savings to Invest or Pay Off a Loan?
Posted On July 13, 2014
A common piece of advice we have all heard is that you should start investing at a young age since saving money might be harder in the future, and you will be left scrambling to have enough funds to retire. This begs the question, if you have an outstanding loan, such as a personal or auto loan, do you use your savings to pay it off early, or invest it instead?
It might seem like it makes sense to start investing now rather than rush to pay off a loan early, but the answer is more complicated. It really depends on the interest rate you are paying, and the investment return. Here is a table of the average interest rates in the UAE (based on reducing rate) so we can look at a realistic example:
Paying off a personal loan
Say someone has a personal loan with a 9% interest rate, and a monthly payment of AED 2,489 for the next 36 months (the initial loan amount was AED 100,000 to be paid over 4 years). After living expenses, this person has AED 4,000 left with which he can either pay the minimum monthly payment on the loan and invest the remaining AED 1,511 or contribute the entire amount to repaying the debt.
If a payment of AED 4,000 is made each month, it will take approximately 21 months to pay off the loan. Now assume that 5% annual return can be achieved on the amount invested, if AED 1,511 is contributed to an investment account each month, after 40 years it will total AED 2.3 million. However, if the contribution is AED 0 in the first 21 months (because all surplus cash is being used to pay off the personal loan), the amount after 40 years will be AED 2.1 million. The higher the rate of return on investment, the bigger the difference will be. So based on numbers, it makes sense to start investing sooner rather than paying off the loan early. But there are other factors to consider.
Firstly, the rate of return, or the amount you have invested, is not guaranteed. You could end up making less money than you hoped, or even losing money. As a general rule of thumb, the higher the rate of return, the riskier the investment. According to bayzat.com, the average interest rate for a savings account in the UAE is only 0.5%! The lower the rate of return on your investment, the more it makes sense to pay off your debt early.
Another risk to consider is if you lose your source of income, and are unable to make your loan repayments. Of course, you can liquidate a portion of your investments in this case to repay your loan, but only if your investments have done well!
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