Utilising Systematic Investment Plans (SIPs) to prepay a personal loan is rapidly gaining traction nowadays as a prudent financial strategy. Still, it comes with both potential benefits and associated risks.
This idea basically involves investing the funds saved on lower EMIs into SIPs, hoping for the returns to outperform the personal loans interest rate. Such an approach assists in enabling the borrower to make early repayment of the loan amount and keep their overall debt level in check.
Kundan Shahi, Founder of Zavo, underscores both the innovation and caution needed: “Prepaying personal loans through SIPs is quite innovative. Historically, equities have offered returns between 12% and 14%, while loan rates hover around 10% to 16%. However, we can’t overlook the potential for volatility. The most prudent approach is a balanced one: make sure to pay your EMIs on time while also directing any extra funds into SIPs. This way, you can reduce your debt without sacrificing your wealth-building efforts.”
How does the SIP prepayment strategy work?
This approach generally requires extending the loan tenure to bring down monthly EMIs. Then the difference between the original EMI and the reduced EMI is invested in mutual funds through SIPs.
Such an approach generally generates higher returns than the personal loan interest rate. For instance, if the EMI is reduced by ₹10,000 per month, then this amount is routed into SIPs. With consistent investments this way, over time, the SIP corpus grows and builds wealth. These funds are then used later on in prepaying the loan principal faster.
Key advantages and risks
- Potentially higher returns: If the equity market performs and the SIP returns surpass loan interest rates, then this strategy can assist in saving funds in the long run.
- Retention of liquidity: SIP investments are liquid, i.e., can be withdrawn quickly. This is unlike prepaying loans or investing in properties or debt. As all such means lock funds. This is a major advantage of mutual fund investments.
- Benefits in taxes: Usually, personal loans don’t offer tax deductions. Still, investing on a systematic basis can grow wealth. Later on, the rebate of ₹1.25 lakh can be taken if the mutual fund investments are withdrawn after one year of holding, according to the tax slab.
- Market risk: The performance of equities, mutual funds, and SIPs primarily depends on market performance. These returns are never guaranteed. They can change rapidly based on the ongoing geopolitical situations.
- Need for a calm, disciplined approach: Missing SIP contributions can bring down expected gains for prepayments. That is why equity market investments demand absolute devotion, calm, and discipline for years together to generate returns.
Is it suitable for personal loans?
This method has been recently gaining popularity, especially with home loans. Still, personal loan interest rates generally range from about 10.5% to 24% on an annual basis and hence are usually higher. This makes it very difficult for SIP returns to outperform loan costs on a consistent basis.
Professionals caution that this strategy is risky if the market returns lag behind loan interest rates. A safer approach may be to prepay personal loans directly or invest in liquid funds to construct a corpus for future prepayment and wealth generation.
In conclusion, utilising SIPs to prepay personal loans can be a clever tactic. Especially if an investor can endure market volatility and maintain composure through disciplined investing.
Still, it carries serious risks of underperformance, short-term capital gains tax in case the mutual fund units are redeemed in less than one year. If you are aspiring to follow this approach, then you should carefully consider the personal loan interest rates, market conditions, and liquidity considerations before following any such approach.
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