Is debt a liability or a lever for growth

You have received an inheritance of Rs. 15,00,000. You also have a home loan of Rs. 15,00,000 @ 8.5%, which is a variable interest rate. Which of the following would you do to maximize your benefit? (For simplicity, we ignore tax complexities and investment costs)

1. Pay off your home loan of Rs. 15,00,000.
2. Invest Rs. 15,00,000 in a diversified equity portfolio
3. Invest Rs. 15,00,000 in equity and fixed-income securities
4. Create an emergency fund by putting the money in a savings account and fixed deposits
    

There may not be a universally correct answer suitable for all as the best course of action depends on the current financial situation. For instance, a person nearing retirement might be better off paying off the home loan. A wealthy and seasoned investor might choose option 2. It is a risky option but also has the potential to generate higher returns. Option 3 may or may not generate returns greater than the interest rate paid for the home loan, and therefore, may not be the optimum thing to do. Creating an emergency fund is important, but putting the entire amount in low-return investments and keeping the loan might not be the best option to maximize returns, though it might be safer.

When it comes to financial status, being debt-free generally makes financial stability easier to maintain. There is also less emotional and relational stress when we do not have loans to repay.

While debt is often viewed negatively, it can be a powerful tool when used and managed wisely. It can act as leverage allowing an individual to make the most of investment opportunities that otherwise might be out of reach and build wealth. For instance, using debt can make it possible to invest in a business, or market opportunities that offer a chance for significant growth.

Debt can be a smart financial tool in a prudent investor’s hands but only makes sense when:

• It is affordable, i.e. interest rates low enough to make it worthwhile compared to other investment opportunities
• The amount of debt is appropriate to the overall net worth of the individual
• Risks are well-understood and tolerable from financial and emotional perspectives
• There is a reliable income stream to guarantee loan repayments during the loan tenure

A fine line between growth and financial burden

Debt is a double-edged sword – it comes with many disadvantages. For instance,  if the cost of borrowing, i.e. the interest payment, is on par or exceeds the returns from the investment made using the debt, you make no money or even lose money. Dealing with debt can negatively impact your mental health. It can lead to stress, anxiety, depression, etc., which can, in turn, affect physical well-being as well. It also affects job performance and personal relationships. Additionally, debt limits our ability to handle life’s uncertainties; without a financial cushion, it becomes harder to navigate market downturns, job loss, or personal life events, such as divorce, leaving us more vulnerable. 

How to use debt prudently

Therefore if you have to use debt, be conservative. Choose an amount that is manageable and aim for optimum returns rather than maximum returns so the risk is lower. The riskier the investment, the less debt should be used to make it. When handled responsibly, debt can offer flexibility, both in life choices and investment decisions, allowing us to benefit from opportunities to build wealth while keeping financial stability within reach.