Bonus money dilemma: Should you pay off debt or invest?

When we handle money, we face many questions and dilemmas. These are ordinary questions. For instance, should you do an RD or should you do an SIP? Or, should you buy a new car or a pre-owned car? Should you take a loan or break savings to buy something? Should you stay on rent or buy a house? At times, we just can not make up our mind as to what is the right thing to do. We face many choices each day and are unsure which to pick. Today, we answer one such question, regarding bonus money. Should you pay off debt or should you invest?

To know more read on.

[caption id=“attachment_517856” align=“alignleft” width=“380”]  First thing to do is decide the type of debt you want to pay off. Reuters[/caption]

Bonus Money:

Many get bonus as part of their salary package. At times, it could be Diwali bonus or a performance bonus. While behavioural finance has shown that our mind treats bonus money different from earned money. And, majority don’t mind spending bonus money on things instead of investing.

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Technically, this is called mental accounting, but simply put, among other things, we treat the same amount of money differently depending on the source.

But, if you are wiser and you want to use this bonus money not to buy the latest gadget and struggling with a dilemma of should you use the money to pay off an existing debt or should you invest this money? Here’s the answer.

Analysis:

Debt: First thing to do is decide the type of debt you want to pay off. To decide on that, know the rate of interest you are currently paying towards the debt. For instance, if it’s a credit card debt, it could be as high as 40 percent per annum. If it’s a personal loan, it would be around 18 percent per annum.

If it’s a car loan, it’s going to be around 15 percent per annum and if it’s a home loan, it’s going to be around 10-12 percent per annum. Keep in mind, that when you pre-pay a car loan, you might have to pay a prepayment charge of 2-4 percent of the outstanding amount. Pre-paying home loan on fixed rate will also come with a fee, but while paying off the floating rate loan you won’t need to pay pre-payment charges.

Investments: Find out what’s the guaranteed rate of interest the investment promises. Keep in mind the word we used here is “guaranteed”. Then, see what’s the post-tax guaranteed returns on the investment.

Answer: Ranjit Dani, Certified Financail Planner, said, “Compare the guaranteed post tax returns of the investment and the cost of the loan. If the cost of the loan is more than what the investment promises, it’s always wiser to pay off the debt first.” So, if you have a credit card debt of Rs 1 lakh and you pay 40 percent rate of interest, it’s wiser to pay off that debt than park your funds in an FD that gives you a post-tax return of 10 percent.

PS: Keep tracking this space for answers to your should I or not questions. And, do let us know your dilemmas too, so we could provide you with answers.