Received a lump sum? Should you start a debt fund SWP to pay the loan EMI?

If you have received a lump sum amount, either keep it in a savings account or start a debt fund SWP to pay loan EMI. A debt fund has the potential to give higher returns than a savings account. But, do consider the taxation aspect.

Savings account vs Debt fund SWP

You may have received a lump sum amount and must be wondering how you can use it to repay an outstanding loan amount. In this article, we will discuss how you can start a Systematic Withdrawal Plan (SWP) in a mutual fund to pay a loan EMI.

What is a Systematic Withdrawal Plan (SWP)?

The Systematic Withdrawal Plan (SWP) is a facility offered by mutual fund houses in which you can withdraw a specific amount from a specific mutual fund scheme at a specified frequency (monthly, quarterly, etc.). An SWP is the opposite of a Systematic Investment Plan (SIP).

For example, Kartik has accumulated Rs. 10 lakhs in an equity mutual fund scheme over a period of 5 years by investing Rs. 10,000 per month. What Kartik has done is a Systematic Investment Plan (SIP). Now, Kartik redeems the money from the equity fund and invests it in a debt fund. He gives instructions to redeem Rs. 20,000 per month from the debt fund into his bank account for the next 4 years. What Kartik has done is an SWP.

Now that we understand what is an SWP, let us understand how we can use it for our benefit.

Also Read: Dividend Plans Vs SWPs: Which One To Choose For Regular Income?

Using SWP for loan repayment

You may have received a lump sum amount either in the form of a bonus from the employer, full and final settlement from the previous employer, prize money from some contest or the maturity amount from an investment. You may be wondering how you can make the best use of this money to pay an outstanding loan amount.

You can either keep this money in a savings account from where the loan EMI is getting debited automatically. In this case, you will earn the savings account interest on the balance, which may be in the range of 2 to 4% p.a.

The other option is to invest the lump sum amount in a debt mutual fund scheme and start an SWP. The SWP amount can be equivalent to the loan EMI amount. The SWP date can be such that the money arrives in the saving account around 3 days prior to the EMI debit date.

Also Read: Good Debt Vs Bad Debt: What You Need To Know?

Benefits of a debt fund SWP

When you get a lump sum amount, you can either choose to invest it in a debt scheme and start an SWP or leave the money in a bank savings account. When you choose the debt fund SWP over a bank savings account, you have an opportunity to earn higher returns. A savings account usually pays 2-4% interest per annum. With a debt fund, you will have an opportunity to earn returns in the 3 to 8% CAGR range, depending on the type of debt fund chosen and the interest rate regime.

Taxation: Bank savings account vs Debt fund

While choosing between a debt fund and a bank savings account, consider the taxation. The interest earned on a savings account is taxable at the individual’s slab rate. However, an individual can get a deduction on the interest amount up to Rs. 10,000 in a financial year under Section 80TTA of the Income Tax Act.

In the case of a debt fund, if the units are sold within 3 years of purchase, the short-term capital gains are taxed at the individual’s slab rate. If the units are sold after 3 years of purchase, the long-term capital gains are taxed at 20% with the indexation benefit.

Factors to consider when choosing a debt fund

When choosing a debt fund, consider the risk involved. While a bank savings account is safe, the debt fund securities are subject to credit risk. Accordingly, choose a debt fund with the lowest possible risk.

While choosing debt funds, look at funds such as money market funds, short-duration funds, overnight funds, ultra-short-duration funds, and liquid funds. The credit risk and interest rate risk involved in these funds are fairly low compared to other funds. Apart from the risk profile, look at parameters such as fund returns, fund manager, assets under management (AUM), scheme portfolio, expense ratio, etc.

Also Read: Where Should You Invest? Bank Fixed Deposits Or Debt Funds?

Actionable insights

  1. Whenever you receive a lump sum payment, you can use it to pay the loan EMIs.
  2. You can leave the money in a savings account that will pay interest in the range of 2 to 4 % p.a. The other option is to invest in a debt fund that has the potential to give returns in the 3 to 8% CAGR range, depending on the type of debt fund, interest rate regime, the risk involved, etc.
  3. You can start a systematic withdrawal plan (SWP) in a debt scheme that will allow you to redeem the EMI equivalent amount to the savings account from where the loan EMI will be debited.

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