SIP or EMI: The F² Rule

Summary

In this video, Pratik addresses a common dilemma: whether to use extra funds to pay off loans or invest in SIPs. Using a home loan as an example, he contrasts the outcomes of paying down debt versus investing in the stock market, factoring in interest savings and potential market returns. He explains the complexities of loan repayments, the impact of sequence risk in investments, and introduces the 'F square rule'—a balanced strategy for loan prepayment and investment. Ultimately, Pratik emphasizes that personal finance decisions are not just about numbers, but about defining one's financial freedom.

Takeaways

• 😀 Consider whether you should use extra money (like a bonus) to pay off a loan or invest it in the market. Both options have pros and cons depending on your situation.
• 😀 Prepaying loans early reduces the principal and saves interest over the long term, but it can also limit your investment growth.
• 😀 A home loan example was used to illustrate how loan payments initially go toward paying interest rather than principal, making the loan feel like you're paying mostly the bank.
• 😀 The Nifty index's average return of 11% was used to calculate the potential returns from investing in an SIP (Systematic Investment Plan) rather than prepaying the loan.
• 😀 Sequence risk in investments means that returns can vary significantly depending on the timing of your investments. This makes it hard to predict future returns, unlike loan payments, which are predictable.
• 😀 While investing can offer higher returns, prepaying the loan guarantees savings by reducing the amount of interest paid over time.
• 😀 If you prepay a loan early, the loan tenure gets compressed, meaning you'll finish paying it off sooner. This can help save on interest in the long run.
• 😀 A balanced approach is recommended: use the F Square Rule to allocate some money to loan repayment and some to investing, allowing for both growth and debt reduction.
• 😀 The F Square Rule suggests a flexible approach where you can adjust the percentage of your income or extra funds that goes toward paying off loans versus investing.
• 😀 If your loan interest rate is higher than your potential investment returns (e.g., 15% or more), it makes sense to prioritize paying off the loan first.
• 😀 Personal finance is not just about numbers and Excel sheets; it also involves emotional considerations, such as the feeling of owning a home or the stress of carrying a large debt.

Q & A

What is the key dilemma discussed in the video regarding handling extra money like an increment or bonus?

The dilemma is whether to use extra money to prepay loans, which reduces the debt burden, or invest it in the stock market through an SIP, which could potentially grow over time.

How is the loan example structured in the video?

The loan example assumes a home loan of 40 lakh rupees with an interest rate of 8.5%, over 20 years (240 months), resulting in an EMI of approximately 34,000 rupees per month.

What happens if you invest the extra 10,000 rupees monthly instead of prepaying the loan?

If you invest the extra 10,000 rupees monthly in an SIP with an assumed 11% annual return, it could grow to approximately 72.33 lakh rupees over 20 years.

What is the main advantage of prepaying a loan instead of investing the extra money?

Prepaying the loan reduces the principal amount, which directly lowers the interest paid over time. This can save a significant amount, especially in the early years when most of the EMI goes toward interest.

How much interest could you save by prepaying a loan in the example provided?

By prepaying the loan with the extra 10,000 rupees each month, the total interest saved would amount to about 17.6 lakh rupees.

What is the actual savings from prepaying the loan after considering the opportunity cost of investing?

After deducting the 10,000 rupees monthly spent on prepayment, the net savings from prepaying the loan would be around 3.87 lakh rupees, which is less than the potential growth from SIP investing.

What is the concept of 'sequence risk' mentioned in the video?

Sequence risk refers to the unpredictability of stock market returns over time. Even though the average return might be positive, the sequence of returns could lead to lower or delayed growth, making stock market investments riskier than loan prepayment.

What is the alternative solution suggested for balancing loan prepayment and investment?

The alternative solution is to use the 'F square rule' or Freedom Fund rule, which suggests a balanced approach of investing a portion of the extra money and prepaying a portion of the loan. The ideal balance varies based on personal financial circumstances.

When should you prioritize loan prepayment over investment?

If the interest rate on the loan is higher than the expected returns from market investments (e.g., above 15%), it's better to prioritize loan prepayment because paying down high-interest debt will save more money in the long run.

How does personal perspective affect financial decision-making in the context of loans and investments?

Personal perspective shapes how people view loans and investments. Some may see loans as burdens that must be cleared for peace of mind, while others might view investments as the key to wealth creation. Understanding how you define freedom and financial success can guide your decisions.