Can you convert loan into wealth?

A loan is often misunderstood to be an avenue to borrow funds only for people who do not have enough money to buy things. However, wealthy people often use loans to achieve their financial goals.

There are two types of people who take loans. The first are those who display either extreme affinity or extreme dislike towards taking a loan. The other kind is those taking a more balanced approach, who borrow funds, but prepay the loan as early as they can. This brings us to the next question when to prepay the loan and when not to, such that you maximise your wealth-making capacity?

There are several borrowers, who prefer to part-prepay or fully prepay the loan as soon as possible, because the thought of being in debt is not very comforting. While prepaying is a personal decision, it may not always make financial sense to prepay the loan. So when should you prepay your loan and when not? You should always look at the opportunity cost of your money before taking this decision.

Let's say you have taken a loan at 9 per cent interest. If you receive a windfall or a bulk amount, which can be used either to prepay a part or your entire loan, or invest this amount, you must first check the post-tax interest you can earn on any investment instrument at that point in time, which best suits your time horizon and risk appetite. If the returns you get from the investment will be below the interest rate you pay on your loan, then it is better to part prepay the loan, in order to save on the interest cost.

On the other hand, if you can find an instrument which gives you post-tax returns of more than 9 per cent, then you should go ahead and invest the amount you have received, and not prepay the loan. Say you have the risk appetite to invest in equity, and you wish to invest in equity mutual funds, which give you long term returns of 13 per cent per annum. Then you will earn 13 per cent per annum instead of saving 9 per cent per annum on the loan. This is the opportunity cost of money. If you choose to prepay the loan to save the 9 per cent interest, you will be losing your potential earning of 13 per cent. So you can build your wealth by investing any windfalls or surplus in higher earning instruments at the same time fulfil your financial goals by taking a loan.

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