Top 3 parameters which differentiate SIP from EMI

Consumerism has seen a tremendous rise in India over the past decade. People have shifted their focus somewhat from savings and have become desirous of owning expensive products and using premium services. Availability of personal loans and widespread use of credit cards has made it easy for people to upgrade their lifestyle. While availing the benefits of either of the above, customers can convert their purchase into Equated Monthly Installments (EMIs). This breaks up their large amount of purchase into much smaller components which does not make the purchase seem as expensive as it is.

At the same time, individuals have also started to emphasize on making investments. The concern regarding financial markets in general and equity investments in particular is giving way. This is reflected in the continual increase in assets under management of equity mutual funds. Systematic Investment Plans (SIPs) offer a convenient way to invest in mutual funds. This service can be set up at the click of a button and allows investors to invest a predefined amount on a particular date periodically, mostly monthly. This money is invested in their choice of fund(s).

Both SIPs and EMIs have some similar characteristics – they make use a small amount to fulfill a larger goal, they are periodic (monthly in most cases), and ease the burden of a large outgo. In order to study their differences, let us first look at some of their chief characteristics.

What is SIP?

SIP stands for Systematic Investment plan. SIP is one of the most significant benefits offered by SIPs is the power of compounding. Starting with a small investment every month, one can build up a sizable corpus even with modest rate of returns. This can be best displayed by the following table:

Monthly Savings Period (In Years) Corpus Without Investment Corpus (@5% returns) Corpus (@10% returns)
2,500 10 3,00,000 3,89,823 5,16,380
2,500 15 4,50,000 6,71,007 10,44,811
2,500 20 6,00,000 10,31,866 19,14,242
2,500 25 7,50,000 14,94,977 33,44,726

It can be easily seen from the table that the more time there is to invest, the bigger the corpus can become. The power of compounding helps multiply an initial investment manifold over a long duration.

Another key aspect of SIP is that of rupee cost averaging. This concept lies at the heart of the facility and states that the cost of holding a security averages out over the holding period. Because of this, investors do not need to worry about the direction of market movement as they get more units of their preferred fund when markets are down and less units when markets are up.

SIPs also inculcate saving and investment discipline. Because this facility puts in place a mechanism of investing a fixed amount in a mutual fund at regular periods, an investor is forced to ensure that he makes this amount available, thus instilling discipline. In this manner, SIPs keep an investor on the right track by first forcing them to save a particular amount, and then investing this amount into the financial markets.

After briefly touching upon the key features of EMIs and SIPs, let’s look at three parameters which differentiate between the two.

To know the best SIP plans by Orowealth click here

Equated Monthly Installments

An EMI is composed of an interest component and a principal component and thus helps a borrower pay off both, in part, every month. Initially, the interest component forms a higher percentage of the monthly payment and as time elapses, the principal component increases its share in the EMI.

The chief benefit of an EMI is that a borrower is aware of the monthly outgo at the time of availing a loan itself, thus enabling him to plan his finances accordingly. An EMI can be calculated either using the reducing balance method or the flat rate method; the former is usually more cost friendly to borrowers.

Three key differences between EMIs and SIPs

Convenience is a shared trait between an EMI and an SIP. However, there are some important differences, three of which are stated below:

(1) Creating an asset while paying for one

While an SIP helps an investor create a corpus for future use, an EMI only helps to pay for an already purchased item. Thus, an SIP involves sacrificing an indulgence at present to save for a more secure future. Meanwhile, an EMI is typically used to satisfy a current need.

This is not to say that an EMI is bad. It helps to convert a large amount into neatly divided, smaller, monthly amounts and can be exceptionally useful in this manner. However, it also needs to be said that because of the availability of the facility, a borrower may be tempted to splurge. On the other hand, an SIP requires steadfast discipline and a focus towards future benefit.

(2) Appreciating versus depreciating asset

This parameter is directly associated with the previous one. An SIP is focused towards the future and always carries an element of uncertainty. There is always a question on an investor’s mind regarding the possibility of SIP not yielding desired results. If due to a series of events, this does turn out to be the case after patiently investing for 15-20 years, an investor may question the veracity of this facility. However, the hope that the results will be more than satisfactory in terms of capital appreciation keep investors interested in SIPs.

On the other hand, the benefit of EMIs depends on the type of asset being purchased for which a loan is availed. If it is an appreciating asset, like real estate, an EMI is immensely beneficial. Because even after spending years on repaying the loan, a borrower may find it useful to have availed of this facility. However, borrowers should be careful while availing of this facility for purchasing depreciating assets like vehicles or payments made on credit cards. These may not be the best uses of the facility.

(3) A payment tool for an asset

This parameter is especially true for a depreciating asset. While an EMI may turn out to be a costly facility to use to pay for, let’s say, a vacation, an SIP may be quite beneficial. If such a purchase is planned weeks or months in advance, an individual may be better off setting up an SIP for such a purchase rather than using an EMI to pay off an unplanned purchase.

We can consider an example for this. Let’s assume the value of purchase to be Rs 1,00,000. If this was planned using an SIP vis-à-vis being unplanned and paid for as a personal loan using an EMI, the following would result:

Loan/Target Amount = Rs 1,00,000
Interest rate EMI Total outgo
12% 8,885 106,620
Rate of return SIP Amount invested
10% 7,892 94,704
Difference 11,916

Even with a modest return of 10%, an SIP would save nearly Rs 12,000 over an EMI.

Conclusion

Both SIPs and EMIs have their uses; which turns out to be better is dependent on the kind of purchase and the asset being purchased. Though one may beat out the other in specific instances, neither can be said to be far superior to the other. Individuals should evaluate both options to choose the one which suits their situation better.