Prepaying your loan could cost you a fortune in lost growth. Is it still the right thing to do?

In the previous edition of ‘Invest Smart‘, we discussed how a simple retirement strategy can help build long-term wealth, highlighting the power of disciplined investing and compounding. In this edition, we turn to another financial dilemma that many earners grapple with at some point—what should you do when you have extra money in hand: repay your debt or put that money to work through investments? This week, we break down the practical principles that can help you make the smarter choice for your money.

Let’s say you receive a bonus of Rs 3 lakh this year. Now you’re wondering – should you pay off a chunk of your home loan and cut the EMI burden or invest that money to build wealth for the future? And if you also have a personal loan, outstanding credit card dues, and a nagging worry about retirement, the question gets even harder.

This is one of the most common financial dilemmas you’ll face as an earner today — should you pay off debt first or start investing?

On one side is the peace of mind that comes from getting rid of debt. On the other is the power of compounding that rewards those who start early.

Social media tells you to “start investing now”, while family says “clear your debts first, then think about everything else”. But here’s the thing — the right answer isn’t that simple.

Not all debts are equal, and not all investments are equal either. A credit card charging 42% interest rate on unpaid dues is a completely different beast from a home loan at 8%. And paying every spare rupee into loan prepayment without an emergency fund in place isn’t always the smartest move.

So what’s the right path? The answer lies not in emotion, but in a few clear financial principles. Let’s walk through them together.

What kind of debt are you dealing with?

Before you can answer “should I pay off debt or invest?”, you need to understand one fundamental thing here – ‘not all debt is the same’. Some debts need to go fast. Others can be managed responsibly while you keep investing on the side.

High-cost debt: Your first priority

If you’re carrying credit card balances, personal loans, ‘buy now, pay later (BNPL)’ dues, or other consumer loans, your top priority should almost always be to pay these off first.

The reason is simple – these loans are expensive. Credit cards in India can charge annual interest rates of up to 42%. Personal loans often run between 12% and 18%, sometimes higher. If you’re thinking of investing that same money hoping to earn better returns, the math is usually working against you.

Think about it this way. If your money is draining out at 42% on one side while you’re investing it expecting 10–12% returns on the other, you’re losing the battle even before it starts.

Manageable debt: Use your judgement

Not every loan is a threat. A car loan or an education loan, for example, may carry relatively lower interest rates and fit comfortably within your monthly budget.

In this case, the decision depends on your income, job stability, interest rate and future goals. If your EMIs are manageable and you still have some surplus each month, there’s no hard rule that says you must halt all investments just to clear this debt.

Is there such a thing as ‘good debt’?

In the world of personal finance, a home loan is often considered a relatively ‘productive’ debt. Its interest rate is significantly lower than a credit card or personal loan, and in many cases it comes with tax benefits (deductions on interest under Section 24(b) and on principal under Section 80C — if you’re on the old tax regime. Note that the new tax regime, which is now the default, does not offer these deductions for self-occupied property).

That doesn’t mean every home loan is a great deal, or that you should take it lightly. It simply means you shouldn’t look at it the same way you look at a credit card bill.

So your first step is this: make a list of all your debts, note down their interest rates, and identify where the real financial pressure is. Often, the answer reveals itself right there.

Is the interest on your debt higher than what your investments can earn?

Here’s a simple thumb rule that cuts through a lot of the noise. If the interest rate on your debt is higher than the return you could realistically earn by investing, pay off the debt first.

Say you have a personal loan at 15% and you’re thinking of putting your surplus into equity mutual funds, which might return 10–12% over the long run. On paper, the investment sounds attractive but here’s the key distinction – mutual fund returns are not guaranteed. The 15% interest on your loan, however, is absolutely guaranteed. You’re paying it regardless of what the market does.

In other words, by prepaying your personal loan, you’re essentially earning a guaranteed, risk-free “return” of 15%. That’s very hard to beat.

Now take a different scenario – a home loan at 8% with a 10–15 year horizon. Here, equity investments could plausibly outperform over time. The decision isn’t as clear-cut, which is exactly why context matters.

One more thing to keep in mind is that taxes change the picture. Investment returns from mutual funds, Fixed Deposits, or other avenues are taxed, which means your actual take-home return is lower than the headline number. Meanwhile, certain loans offer tax deductions that reduce their effective cost.

So don’t just compare the surface numbers. Look at the true cost of the debt versus the actual net return on the investment.

The bottom line: high-interest debt? Clear it first. Low-cost, manageable debt? You may be able to invest alongside it.

Warren Buffett agrees: High-interest debt has to go first

If you needed a powerful endorsement of that logic, here it is. Warren Buffett, widely regarded as the world’s most successful investor, isn’t just known for picking great stocks. He also has a very firm view on debt, especially high-interest debt.

In a well-known exchange, a woman who had unexpectedly come into some money asked Buffett where she should invest it. His first question to her was “Do you have any outstanding credit card debt?” When she confirmed she had a card with an 18% interest rate, Buffett’s response was immediate and direct: “If I had debt carrying an 18% interest rate, any money that came my way, I would use it to pay off that debt first. I don’t know where I could consistently earn a return of 18%.”

That is the single most important lesson in this entire discussion. If your money is flowing into debt that carries 18%, 24% or even 36% interest, simply starting to invest won’t solve your problem. Investment returns are never guaranteed, but the interest on debt is fixed and keeps compounding, relentlessly, every single month.

Buffett also warns against the trap of easy credit. He believes that credit cards make overspending feel painless in the moment until those same expenses come back to devour your income through heavy interest payments.

Think of high-interest debt as “negative compounding”. Just as money grows over time through smart investing, high-interest debt also grows rapidly over time — except it’s working against you.

Don’t have an emergency fund? Don’t pour everything into loan repayment just yet

Here’s a mistake many people make – the moment they get a bonus or some extra cash, they channel the entire amount into loan prepayment. It feels responsible. But it isn’t always wise.

Ask yourself this, what would you do if, the very next month, you lost your job? Or faced a medical emergency at home? Or got hit with a large unexpected expense?

If all your savings have gone into loan prepayment, you’d likely turn to credit cards, take out another personal loan, or borrow from friends and family. In other words, you’d be right back in the debt cycle you were trying to escape.

This is why financial planners consistently emphasize that building an emergency fund — either before you start repaying aggressively, or alongside your repayments — is non-negotiable.

Generally, aim to set aside at least six months’ worth of your essential living expenses. If your income is irregular, you’re a freelancer, or your family depends entirely on your earnings, extend that to 9–12 months.

Think of your emergency fund as your financial airbag. You hope you never need it but when difficult times hit, it’s the first thing that protects you. Being debt-free but cash-strapped is its own kind of financial danger. The smart strategy is one that gradually reduces your debt while keeping a cushion for the unexpected.

Stopping all investments to repay debt can also be a mistake

There’s no question that getting rid of high-interest debt is critical. But freezing every single investment regardless of what kind of debt you hold isn’t always the right call either.

This is a mistake young earners make often. The thinking goes like “let me clear the home loan or education loan first, and I’ll start investing after”. It sounds disciplined. But it can come at a very high cost — the loss of precious years of compounding growth.

Say you’re 30 today and you decide to focus entirely on repaying loans for the next 8–10 years, planning to invest only after that. The problem? In investing, time is just as powerful as money. The earlier you start, the more compounding does for you. Waiting a decade to begin can cost you far more in lost growth than you saved in interest.

So if your debt carries a relatively low interest rate — like a home loan — and your EMIs aren’t breaking your budget, you don’t need to stop investing entirely. You can keep making small SIP contributions.

Continue your retirement contributions — EPF, NPS or both.

When you get a bonus, split it — a portion toward loan prepayment, the rest toward investments.

Ten years from now, “I wish I’d started investing sooner” can be just as painful as “I wish I’d cleared that high-interest debt sooner”. If your debt isn’t drowning you, there’s no need to completely stop building for the future.

The tax angle: Useful to know, but not the deciding factor

Taxes do play a role in this decision, but they shouldn’t be the main driver.

For instance, if you’re on the old tax regime, home loans come with useful deductions — you can claim up to Rs 2 lakh per year on interest paid (Section 24b) and up to Rs 1.5 lakh on principal repayment (Section 80C). Education loans can also qualify for tax relief under Section 80E. These deductions reduce the effective cost of your debt on paper.

However, if you’ve opted for the new tax regime, which is now the default, these deductions are not available for self-occupied property. So check which regime applies to you before factoring tax savings into your calculations.

A common mistake here is that people hold onto loans longer than they should simply because they’re “saving on taxes”. But if your EMIs are straining your cash flow, causing you stress, or crowding out other important financial goals, holding onto debt just for tax savings is not sound reasoning.

On the flip side, your investment returns are also taxed. Gains from mutual funds, Fixed Deposits, or other avenues don’t come to you in full — the actual return after tax may be meaningfully lower than what you see advertised.

The takeaway: taxes are a supporting factor, not the headline. Your primary decision should be driven by your cash flow, your interest costs, and your financial goals.