Should You Redeem Investments or Take a Loan?

In the last decade, banks and NBFCs like Bajaj Finance have taken loans to the masses by making them easily available at the point of sale. In the last few years, tech-savvy startups, in collaboration with banks and NBFCs, have made loans further easily accessible by bringing them to the customers' fingertips. Today, you can get a loan at a click of a button on your mobile.
 
With so many sale events, online and offline, going on throughout the year, there is always a temptation to buy so many things, some of which you may or may not really need. Financing the purchase is not a problem with a plethora of options like credit cards, 0 interest EMI schemes, personal loans, paying through UPI/debit cards, or redeeming investments. Let's find an answer to an important question of whether you should take a loan or redeem investments to finance the purchase of a product.
 Redeem Investments or Take a Loan
 
 
 

Start your SIP today!

What is Debt to Income (DTI) Ratio 

Before we answer the question of financing a purchase through a loan or redemption of investments, let us understand the important concept of debt to income (DTI) ratio. The debt-to-income (DTI) ratio measures the percentage of monthly income an individual uses for making monthly debt payments. The DTI ratio can be calculated by dividing the monthly debt payments by the monthly income.

 

DTI = (Monthly debt payments / Monthly income) * 100

 

For example, if your monthly income is Rs. 40,000 and your monthly debt payments are Rs. 8,000, your DTI ratio will be 20% ((8,000/40,000) * 100). It means 20% of your monthly income goes towards monthly debt payments.

 

The lower the DTI, the better, other things being equal. A lower DTI indicates you are managing your debt payments well with your income. For financial well-being, pay attention to your DTI. It is recommended that you keep your DTI at 20% or lower. If it is high, work towards bringing it down to manageable levels. A lower DTI will free up more money for expenses, savings, and investments, giving you much-needed peace of mind.

How to Finance Purchases?

So, now you understand the dti ratio concept, the recommended level, and how to manage it. Let us now go back to answering the earlier question of how to finance purchases, whether through aLoanor redeeming investments.
 

Short-Term Goals


Many of us have short-term goals like annual vacations, purchasing the latest mobile or gadget, purchasing a consumer durable, purchasing a two-wheeler, painting the house or home renovation, etc. The timeline for these goals is usually a year or less. You can fulfil these short-term goals either from your regular cash flows, a short-term loan, or partly from both.

While taking a loan for these short-term goals, ensure that your DTI ratio stays below 20%, the loan tenure is short (3 to 12 months), and the EMIs are easy to manage from your regular cash flows. If you already have other loans running, taking an additional loan may push your DTI beyond 20%. In such a scenario, if possible, check if you can postpone the short-term goal by a few months. It will give you time to finish repayment of earlier loans and make space for a new loan.

Postponing the short-term goal also gives you time to accumulate money and pay for the purchase from your pocket rather than financing it with a loan. It is not a good idea to dip into your emergency.

fund or redeem your investments (mapped to long-term financial goals) for fulfilling these short-term goals.

Medium to Long-Term Goals


Medium to long-term goals may include buying a car, building a fund for one’s own higher education and/or marriage, buying a house, home renovation, international family vacation, etc. The timeline for medium-term goals may be 3 to 7 years and for long-term goals is usually beyond seven years. You can fulfil these medium and long-term goals by redeeming investments meant for these goals, through loans, or partly from both.

In case of most of these goals, you may take the following approaches:

Funding Purchases With a Loan


 
For goals like higher education, you may fund it with an education loan. Over here, time is of the essence as you need to enrol for the course at a specified date. Hence, you may or may not have the luxury of time to accumulate money by making investments for it.

Also, going for an education loan has certain benefits like a moratorium on EMIs till you finish the course and start earning, tax benefits on interest paid under Section 80E of the Income Tax Act, lower interest rates compared to other loans like personal loans, etc.

Funding Purchases With a Combination of a Loan and Redeeming Investments


For goals like buying a car and a home, you will have to use a combination of redeeming investments meant for these goals and loans. Purchasing a car and a home requires you to make a down payment equivalent to up to 20% of the car/home value.

So, you will have to plan for these purchases and make investments to accumulate the down payment amount. Once you have accumulated the amount, you can redeem the investment and make the down payment. You can go for a car loan or home loan for the remaining amount.

While taking a loan, you must ensure your DTI stays within manageable limits. For certain goals like home purchase, if your DTI goes to 30-35%, it is okay in the initial period as it is an essential once-in-a-lifetime purchase. After taking the loan, you should work towards bringing down the DTI to levels of 20% or so. Also, a home loan comes with the benefit of tax deductions on principal repayment (under Section 80C) and interest payment (under Section 24).

Important note: For making the vehicle/home purchase down payment, you should redeem only those investments that are mapped/meant for these specific goals. You should avoid redeeming investments meant for other financial goals. Doing that will jeopardise your financial planning process.

Funding Purchases by Redeeming Investments


For goals like wedding, home renovation, international family vacation, etc., it is better to plan for these in advance. With goal planning, you can calculate the amount required, the time horizon, and the expected rate of returns, and accordingly start making the required investments through SIP.

Once you have accumulated the required amount, you can go ahead and redeem the investments and use the amount to fund the purchase. Funding these goals through loans can stretch your DTI ratio, and the EMI payments can put pressure on your cash flows. Hence, it is best to avoid loans for these goals and instead fund them by redeeming investments meant for these goals.

What if you have accumulated a majority of the goal amount (70-80%), and the goal date is arriving? You can take a short-term loan for the remaining amount and repay it at the earliest.

Important note: As mentioned in the earlier section, you should redeem only those investments that are mapped/meant for these specific goals. Avoid redeeming investments meant for other financial goals, else it will land you in a financial mess.

Purchases Funded With Loans Provide Benefits


Some people consider loans as bad and prefer to avoid them completely. However, it is okay to take certain loans that provide you specified benefits like:

  • An education loan helps you earn a specified degree/certificate that can help you get a job and create an income source or enhance your existing income.
  • A home loan helps you create an asset (home) where you can stay, and has the potential to appreciate in value in future.
  • A car bought with a car loan gives you the convenience of travelling to your workplace and other places.

Prioritise Repayment of High-Cost or Long-Tenor Loans


We have discussed various scenarios on how you can fund purchases with loans, redeeming investments, or a combination of both. Whenever you take high-cost loans such as personal loans, credit cards outstanding, etc., you should prioritise their repayment. If the credit card outstanding amount is high, don't revolve it with minimum payments. You will end up paying 36 to 45% p.a. interest. Covert it into a fixed EMI loan at a lower interest rate.

For longer-tenor loans such as Home Loan or a car loan, it is important to have a focused approach towards their early repayment. Proactively paying off these loans can significantly reduce the impact of interest outflow. Having a clear goal towards repayment can also ensure peace of mind and financial savings that can be redirected towards crucial goals like retirement.

Loan

Tenor *

Interest Rate *

High Cost

Long Tenor

Credit Card

Up to 20 days from bill generation date

9-45%

✅

❌

Personal Loan

6 months to 3 years

12-15%

✅

❌

Car Loan

3 to 7 years

9-11%

❌

✅

Home Loan

5 to 20 years

8-9.5%

❌

✅

Loan Against Shares

1-3 years

11-13%

✅

❌

Strike a Balance Between Needs and How to Fund Them


You should never fulfil your short-term requirements by redeeming long-term investments meant for fulfilling your long-term financial goals. Doing that will derail your financial planning journey. Short-term needs are best fulfilled by planning them and accumulating money for them. In some scenarios, you can fulfil them with short-term loans.

For specific needs like a car or a house purchase, you will have to use a combination of redeeming investments meant for these specific goals and loans. While availing of loans, ensure your DTI ratio stays within manageable limits. Even if it goes higher in the short term, ensure you work towards lowering it and maintaining it at manageable levels. Thus, loans can help you strike a balance between needs and how to fund them.
 

Achieve your goals with SIP's