Don't Put All Your Eggs in One basket

We frequently come across individuals who are very finance-savvy but have taken a fancy to one particular asset-class and are totally convinced that it is the best one to sail them through their life. This bias is seen mostly in real-estate investments and in equity investments(stocks or shares, as they are variously called). Unmindful of the danger it poses to their long-term goals, they continue to invest all their investible suplus in their favoured avenue without caring about one of the Golden Rules of Investment - Diversification of assets.
What is diversification? Diversification means spreading your investments over a number of investment avenues.
Why do we need to diversify our investments? Why should we not put it all in only one type of investment which we think is the best? Let’s look at the example below.


A man wants to sell eggs to buyers in the city. He will carry the eggs in a basket and will travel across from his village to the city. The whole process will be done as below:
• Buyers will buy all the eggs in the basket.
• Each egg will sell for Rs 2.
• If a basket carrying the eggs drops, all the eggs inside the basket will be broken.
• Buyer will not buy broken eggs.
• There are total 50 eggs to be carried.


1st scenario: put all the eggs in One basket. The man puts all the 50 eggs in one basket and carries to the city. The money he can get from selling the eggs will be as below:
Possibility       Eggs Safe Eggs Broken Profit (Rs)
Basket safe        50             0              100
Basket drops        0             50               0
The maximum net profit the man can get is Rs100. If he drops the basket, he will get nothing.

2nd scenario: put all the eggs in 2 baskets. The man distributes the 50 eggs into two baskets and carries to the city. Each basket will have 25 eggs. The money he can get from selling the eggs will be as below:
Possibility                    Eggs Safe Eggs Broken Profit (Rs)
2 baskets safe                50             0              100
1 basket drops,1 safe     25             25              50
2 baskets drop                0              50              0


3rd scenario: put all the eggs in 5 baskets. The man distributes the 50 eggs in five baskets and carries to the city. Each basket will have 10 eggs. The money he can get from selling the eggs will be as below:
Possibility                   Eggs Safe Eggs Broken Profit (Rs)
5 baskets safe              50             0              100
1 basket drops,4 safe    40             10              80
2 baskets drop,3 safe    30             20              60
3 baskets drop,2 safe    20             30              40
4 baskets drop,1 safe    10             40              20
5 baskets drop               0              50               0


Below is the summary of the above three scenarios:
Scenario No  Profit That Can be earned (Rs)
1st scenario           0 / 100
2nd scenario       0 / 50/ 100
3rd scenario    0/ 20/ 40/ 60/ 80/ 100


In the 1st scenario, which is to put all the eggs in one basket, the man can either get Rs100 or nothing at all. In 2nd scenario, in addition to Rs 100 or Nil, the man also has the possibility of getting Rs 50. In 3rd scenario, the man can get Rs 100 or Rs 80 or Rs 60 or Rs 40 or Rs 20 or nothing.
So, which scenario do you think is the riskiest? Obviously, 1st scenario because you just cannot afford to drop the basket. In other scenarios, you may get something if you drop one or more baskets.
Do you now know why people like to say do not put all your eggs in one basket!
Remember, the main purpose of diversification is to reduce investment risks to your money as some risks can be diversified away.
[Adapted from a web-post on www.ericfinance.com]

State Bank of India 5-Year Tax Saving FDs: Truth Told - Ashwathama Style!!

Take a 5-year Bank Fixed Deposit (FD) in the largest bank in India and get interest upto 18.55% per annum. Too good to be true – State Bank of India says so! The offering is:-

Put in Rs 10,000 in a 5-year FD with the bank at 9.25% per annum to get back Rs 15,797/- after 5 years. However, since you get a tax saving of Rs 3090 under Income Tax Section 80C, assuming a tax bracket of 30%, your net invested amount is actually Rs 6910/-. Thus, getting back Rs 15,797/- on an investment of Rs 6910/- after 5 years amounts to an annualised return of 17.77%. (Similar calculations for Senior Citizens, who get an interest of 9.75% amounts to a return of 18.55%!!)
Is it true? Can an almost risk-free investment give you 17.77% return?
If so, why does anybody need to invest into anything else ever....?
We have heard of people who have put in substantial amount of their money in such FDs, taking the contents of the advertisement to be the whole truth.
Actually, State Bank of India’s advertisement is Truth - Ashwathama style! What it does not reveal to you is the following:-
1. When the FD matures after 5 years, you would have to pay tax on it as per your tax slab. If you are in 30% slab now (the advertisement calculations are done on this tax slab) and continue to remain so, then your interest gain of Rs 5797/- would get reduced to Rs 4005/- due to a tax liability of Rs 1791.27.
2. It presupposes that you have not already used up your tax-saving limit of Rs 1 Lakh under Income Tax Section 80C. This is the same section under which you claim your major deductions for Provident Fund (PPF / EPF / DSOPF / Company PF), NSC, Life Insurance Policies’ premium (including AGIF/AFGIS/NGIS), children tuition fees and principal part of your Home Loan. If you are already in 30% bracket (or even 20% bracket), there is very less likelihood that you would not have already exhausted this Rs 1 Lakh limit under IT Sec 80C.
If the above two conditions apply to you, then, with SBI paying you 9.25% interest, your post-tax returns after 5 years would actually amount to a mere 6.96% per annum only and not the fancy 17.77% being advertised by SBI!! Also remember that in this type of tax-saving FDs, there is no facility of premature withdrawal, even with penalty.
In fact, there are much better ways to save tax under IT Sec 80C, like Provident Fund, Equity Linked Savings Schemes of Mutual Funds etc, than these FDs, notwithstanding the slick advertising.
If instead of 30% tax bracket, you are in 20% or even 10% tax bracket, but have used up your Rs 1 Lakh limit of IT Sec 80C, your actual post-tax returns after 5 years would still be only 7.88% and 8.75% per annum respectively.

Moral of the Story: It is YOUR hard-earned money. Consider all the possible angles or consult an unbiased Financial Advisor before you make any major financial investments. Look before you leap is the mantra!

How to align your Investments with your Personal Financial Goals

I have been invested in Equity mutual funds for the past one year and have barely made enough money in it even to pay your fees! I am worried – will I lose my money? If it is to continue like this, should I put my money only in Bank FDs – at least the interest rates are high for now and they are safer?

For the past few months, we have been getting such emails or telephone calls where people invested through us (or elsewhere) pose their dilemma. This clearly reflects the grief that almost everybody is experiencing with the state of stock markets today. Though the markets have run up quite well in the past 7 weeks, with some financial pundits pompously predicting that The Bull Run is Back, the volatility of this week has got the original question doing the rounds again.

While the question does indicate anxiety of investors, it also brings out the investors’ non-comprehension of correlation between one’s life-time goals and the various avenues available for investing. This further begets the question – how should one go about deciding how to invest his money, whether a lump-sum or monthly savings or both? This article will aim to sort out this basic issue.

The very first thing to understand is that if we do not know (or are unclear about) what we wish to save for, we will never be able to save for it!! It simply means that if we do not specifically save for life’s major financial goals, it will be very difficult to remain on track to do any meaningful investments. The temptation to dip into savings at the smallest pretext will be too much to resist, resulting in a scramble when those big-ticket expenses actually arrive. And what could be those financial goals – anything that consumes a lot of your money and is something which you have to or want to spend your money on. The goals could be children’s higher studies (graduation and post-graduation), their marriage, a comfortable retirement, regular domestic and/or international vacations, changing your car every 7-10 years, donating regularly for a charity etc. For example, if you know a particular saving avenue is to fund your daughter’s marriage, you would touch it for anything else only if you have your back to the wall.

The next thing that comes up is how to decide where to save the money? Primarily, money can be saved in four types of asset classes: Debt (eg, Provident Fund, Fixed Deposits, debt mutual funds, and Government schemes like NSC, Post Office schemes & Government bonds), Equity (direct stocks, equity mutual funds, ULIPs), Real Estate and bullion (precious commodities like Gold, Silver, Platinum and Palladium). Each asset class has its own peculiarity as below:-

Debt: Capital is protected but returns may just about match the inflation. A portfolio consisting of pure debt assets is not likely to be able to meet your long-term financial goals.

Equity: Investments in equity guarantee a roller-coaster ride in the short-term! Implying, one should understand that equity will have dismal returns and bumper returns at varying points of time. But carefully selected portfolio which is well-monitored can give returns far in excess of general inflation rate over a long period of time – generally beyond 3 years. Thus, equity is good for long-term but may be unsuitable for short-term goals.

It is said that you trade in ‘Debt’ while you invest in ‘Equity’, meaning that you should invest in debt-related instruments for your short-term goals (less than 2-3 years’ horizon) while invest in equity-related instruments for your goals beyond that time horizon. It also implies that, as a particular goal approaches nearer, move the money invested in equity for that particular goal gradually to debt assets.

Real Estate: Location, price and builder (if taking an under-construction property) are the 3 crucial aspects. General misconception that real-estate will only go up, has been proved wrong time-and-again. Also remember that real estate requires bulk investments, is fairly illiquid if wish to sell it in a hurry and there is a need to look at inflation-adjusted percentage returns of the property rather than only the bulk money returns. It is well documented that over a time-horizon beyond 10 years, equities in general give better returns than property in general! A portfolio consisting of largely real estate can lock you in badly when need arises for cashing it in a hurry.

Bullion: Referring primarily to Gold, bullion generally gives returns matching the rate of inflation. Notwithstanding the way Gold has risen in the past 1 ½ - 2 years, Gold should only be seen as a hedge against inflation, rather than as an investment tool.

With the above as background knowledge about various asset classes, how should one go about investing and saving for life’s future major goals. We give our take below:-

1. Decide on your life’s major Financial Goals and save for them. And while doing that, do not forget about Retirement, where you are likely to spend around 20-30 years of your life. Another word of caution, if you are in receipt of your employer’s pension, don’t count on it to entirely fund those 20-30 years unless you are ready for major financial compromises in later years of life.

2. Invest as per your Risk profile. How much of equity-related products are you comfortable with? Does huge investment in property make you lose a night’s sleep. Take a test on our website at http://www.humfauji.com/risk.aspx.  

3. Decide your Asset Allocation Percentage. Not all eggs in one basket. Change and rebalance it as per changing times – markets, your age and your requirements. Invest in assets with negative correlation amongst themselves, eg, last 5 years’ data indicates that there is hardly any correlation of equity with Gold as also debt instruments in India while it has a very high positive correlation with real-estate. Debt instruments for short-term goals, equity for long-term, some Gold for balancing and some property (one house to stay, one for good rentals).

4. Look beyond Fixed Deposits as part of fixed income allocation. Debt instrument returns get hugely affected by their taxability aspects. Since their returns barely match the inflation, if you further get taxed at 30% on it, a FD of 9.5% will effectively give you only 6.56% return! Instruments like Debt Mutual Funds are far more tax-efficient while being almost as safe.

5. Plan investments across various time-frames. Plan for short-term, medium-term and long-term. Do not mix them. If due to some urgent unavoidable requirement you have to take out money from your long-term funds, do remember to fill back that ‘bucket’ at the earliest opportunity.

6. Tax saving should not cloud your investment needs. Do not invest a large amount or take on a long-term commitment merely for the sake of saving tax. Eg, a Government officer taking medical insurance to save tax under IT sec 80D, buying a property only to get tax advantage on home loan, insurance policy only for tax purpose, are all potential money-wasters.

7. Once invested, be patient for results. Equities will be volatile in the short-term; Property will not shoot up just because you have bought it now; Debt returns will just about match inflation... However, do not hesitate to book losses if you find that results do not match expectations even after you have given it its due time.

8. Invest in an asset class as per its peculiarities. Each asset class has its peculiarities which should be understood and researched BEFORE investing in it. The best way to invest in equity mutual funds is through Systematic Investment Plans (SIPs) and Systematic Transfer Plans (STPs), lock-in into debt products when interest rates are high, invest in all equity-related products when everybody is professing nothing but gloom and doom, etc.

9. Invest in a Financial Advisor and a life-time financial plan for yourself. Like you need a doctor for good physical health and a Guru for good spiritual health, you need a Financial Planner for your good financial health. Similarly, like a full-body health check-up, you also need a life-time financial plan to be made for you so that you know how to reach where you want to go to.

Investments for the recently Retired in India

Retirement marks the beginning of a new phase in an individual's life. It's a transition from a lifetime of work to a time when one can relax, spend time with the family and pursue other interests, which somehow take a backseat when on a regular job. Not only this, retirement also marks a transition in one's finances. With a regular stream of income no longer available, the savings made over one's working years now have to provide for all his needs. Even if one decides to go in for a second career (eg, in case of Defence Officers who retire early or others who may find another job in private sector due to skills acquired during working life), it will be for a limited period of time till, say, 60-65 years of age. Taking a life-expectancy of 85 years, there are still 20-25 years of non-earning life to be lived, with a challenge of increased expenses (large number of career-related perks not available now) and desire to maintain at least the same living standard as while earning. For such investors, capital protection and liquidity are priorities. In this article we profile some investment avenues that retirees can consider adding to their portfolios.

Retirement can be an ugly word if you do not have an investment plan and have no idea how inflation can deplete your finances. But it need not be if you can ensure a steady flow of income that can sustain you for 20-25 years after retirement. How does one go about it? First assess the amount you need per month depending on your expenses and lifestyle. Then, based on your corpus and risk appetite, opt for an appropriate scheme. Instead of investing in a single scheme, do so in a bunch of instruments, which not only assure regular income but also allow your corpus to grow in tandem with your withdrawals and rising inflation. This strategy should alter with age or stage of life after retirement. So, for the first six to eight years after you retire, allow your funds to grow at faster rate than the withdrawal. Even as you use the interest earned through debt options to meet your expenses, invest in equity through mutual funds or monthly income plans. In the next 10 years or so, your withdrawals should broadly match the growth of your portfolio. As you look at a higher monthly income through systematic withdrawal plans, you can reduce your exposure to equity. Beyond this period, you can use more of invested capital and significantly reduce the focus on growth. If you are not able to sustain the corpus and own a house, opt for the reverse mortgage scheme

Notwithstanding the above, there is a misconception amongst such investors that one should invest only into extremely safe avenues on or nearing retirement. It has to be kept in mind that the primary aim of all investments is to make the money grow more than inflation, and this aim remains constant, whether you are still working or retired. To explain this, consider Indian scenario where the average long-term annual rate of inflation is about 8%, implying that whatever costs Rs 100 today, will cost Rs 108 next year. Thus, if your income-tax adjusted returns are not anything more than Rs 8 per year on that Rs 100, then the actual worth of your money is effectively getting eroded each year. The wider implication of this is that, while your expenses will rise with inflation, you will have lesser money available each year and a time will come when a cut-back in the standard of living will become imperative. The only investments that make it possible with adequate liquidity are necessarily equity-related like stocks, mutual funds and ULIPs. However, one has to take a call on how much risk is acceptable to him/her. Those retiring from a job which provides them a pension, like Government employees, are a bit lucky as they get pension on retirement; but there is one negative thing attached with this – pension keeps people in illusion that pension will be sufficient for them to have a comfortable retirement for all their expenses like household expenditure, leisure activities, vacations, repairs & maintenance of house, social obligations and maybe some liabilities which are still balance to be tackled.. They forget that pension will be close to half of their income, the basic pension gets frozen with only DA rising over the years (except maybe on a Pay Commission review) and that the expenses that are currently borne by the exchequer, are not available after retirement.

Ideally, the entire corpus available with an individual on retirement (as also additional monthly investments, till the capability exists) should be related to individual goals like children’s education and marriage (whatever liability is still balance at the time of retirement), steady and steadily increasing regular income, vacation expenses, social obligations etc, and availability of enough liquidity in investments so that emergency requirements can be easily met. To this end, the money available needs to be invested in an array of instruments which meet the desired financial goals while still taking only those risks which are acceptable to the investor.

Likewise, the retiree's requirements will also play an important part in the portfolio creation. For example, a retiree who is well off and supported by his family may not need to fend for himself. Instead he might be keen on investing for his grandchildren and other family members. In such a scenario, the investment tenure goes up, as does the opportunity to take on higher risk; equity-oriented funds emerge as a very feasible option for a longer time-frame.

Finally, don't undermine the importance of a qualified and experienced investment advisor. Powered by expert advice and prompt service, a good investment advisor can ensure that your post-retirement investments become a hassle-free affair.

(In a sequel to this post, we will discuss the actual investments available to retired investors and how to choose what is good and comfortable for them)

IS YOUR BANK FIXED DEPOSIT CHEATING YOU??

IS THERE AN ALTERNATIVE TO A BANK FD FOR SAFE INVESTMENTS?

Nobody likes to lose money. The most common refrain that I hear as a Financial Planner is – “I may not make much money, but I don’t want to lose any ever!” Why not - after all it is your hard-earned money, why lose even a bit of it? But then that person puts the very same money in a Fixed Deposit (generally of a bank, sometimes in a Company) for a few years, without realising that he has done exactly what he wanted to avoid!!

Let’s give it a closer look. Let’s say you have Rs 5 Lakhs which you want to invest in a safe place for 3 years. Let’s also say that your bank offers you a good 9.5% per annum (pa) rate of interest. You go ahead with the FD and expect the interest of Rs 1,42,500 three years later at 9.5% per year. But, when your FD matures, your bank deducts 10% TDS (Tax Deduction at Source) and when you file the Income Tax Return at the end of the Financial Year, the balance 20% tax also needs to be paid (assuming you are in 30% tax bracket). Thus, you actually get Rs 98,470 as the interest – amounting to just 6.56% per annum! Not only bank FDs, Post Office and Company FDs are also similarly treated tax-wise.

Can you do anything about it? If I were to tell you about an investment avenue which is almost as safe, gives you much better returns, is tax-efficient, may or may not have any lock-in period and you can keep adding or taking out money from it as you desire, what would you say? ‘Wow’! I am referring to debt Mutual Funds (MFs) here. You may be surprised. Aren’t MFs supposed to invest in stocks only? Not at all. In fact, out of a total of Rs 6.54 Lakh Crores invested in MFs in India today, approximately 70%, ie Rs 4.5 Lakh Crores or so is in Debt-based funds and only about Rs 2 Lakh Crores in Equity MFs!

The debt route in MFs

Debt mutual funds are like equity mutual funds. But instead of stocks, they invest in government bonds, corporate bonds, certificates of deposit generally of banks, commercial papers of companies and other fixed income instruments of varying maturities. They have lower risk than equity mutual funds; as a result they have lower returns too, but that is offset by the high safety that they provide to investors. Even though debt funds invest in fixed income instruments, the returns from debt funds are not fixed as in a bank FDs but vary as per the general interest rates prevalent in the economy. However, investing in debt funds like Income Funds which have longer maturity papers and the FMPs (Fixed Maturity Products) of long durations (1 to 3 years) give you interest rate protection over long periods.

Having seen the safety aspect of Debt MFs to be similar to bank FDs, let us go back to the original topic – how are they better than bank FDs. It is so due to their lower taxation rates as also indexation benefits; latter - if held for a period longer than one year. In case of Debt MFs, if the fund is held for less than a year, then its taxation on the interest (called Capital Gains in case of MFs) will be the same as a bank FD though rate of interest earned may be slightly higher along with the attendant advantage of the flexibility to take out your money any time. If the fund is held for a period longer than one year, the maximum tax rate applicable on the Capital Gain will be 10% if no indexation benefits are taken. If indexation is applied, it is 20% but your tax is reduced depending on the rate of inflation in the economy and there is likelihood that you may pay no tax at all! Let’s see how does it work?

In indexation, the cost of investment is raised to account for inflation for the period the investment is held, if the period of investment is anything more than One year. This is done by using a cost inflation index number released by the tax authorities every year. For instance, take an investor who bought debt fund units worth Rs 50,000 at Rs 10 per unit in March 2008. He then sold off all the units in April 2009 (after 13 months) at Rs 11.02, getting a return of 9.5% per year. Since the units were held for more than 12 months, it is termed as ‘long-term’. You have the choice of either paying tax at the rate of 10% or take the benefits of indexation, whichever is beneficial to you. Let’s see how indexation works. The base year for the cost inflation index number is 2007-08 (as the units were bought in March 2008), and the index number was 551. The year of sale is 2009-10 (as the units were sold in April 2009), the index number was 632. The notional cost for acquisition of the units for the purpose of tax calculation will therefore be increased to Rs 57,350 (50000*632/551). The sale price is Rs 55,100 (=5000 X 11.02). Since the notional cost price (as increased by rate of inflation) is more than the sale price, there is no gain and hence, no tax! Thus, even though investor has made a good gain, the cost inflation working (indexation) has wiped it out notionally. Had this investment been made in a Bank FD at same rate of interest and the investor was in 30% tax bracket, he would have paid a tax of Rs 17,026 on the gain. This phenomenon has happened due to high inflation – even if the inflation were low, the tax paid would be much lower than for a similar Bank or Company FD.

The end of a financial year gives an opportunity to investors to get this double benefit, using the indexation route. The double indexation benefit is for investments that need not be locked in for a two-year period, but for at least over a year. However, beware that this double indexation benefit may get abolished in the current form in new Direct Tax Code (DTC) and indexation may get linked to actual period of holding.

Options in Debt MFs

Debt funds have a fairly wide range of schemes offering something for all types of investors. Liquid funds, Liquid plus funds, Short term income funds, GILT funds, income funds and hybrid funds are some of the more popular categories. For long term investors, debt income funds provide the best opportunity to gain from interest rate movements. There is also the short term plans for investors looking to invest for periods of 1-2 years. Liquid funds can be used for very short term surpluses, as a better alternative to surplus money lying in savings bank account. Fixed maturity plans (FMPs) have been gaining in popularity lately as they minimize the interest rate risk and offer good returns to debt investors. Those emphasizing shorter term securities and higher credit quality tend to be more conservative than ones offering longer maturities and lower credit quality. More conservative funds generally hold out the prospect of reasonable returns and low risk exposure, while aggressive funds seek to offer higher returns in return for accepting higher risk exposure. As the relative risk profile of such securities is higher, investors in such bonds expect higher income streams compared to higher-rated bonds.

Summarising on Debt Mutual Funds

In the investment world, it is not an either/or scenario between debt and equity. Basic principle of sound investing postulates a diversified portfolio. Though debt funds often may just be the difference between being able to retain the profits and losing it all in the next round of volatility, the main advantage of debt funds is relatively lower risk and steady income in addition to liquidity of investments, professional fund management expertise at low costs besides diversification of portfolio to have a balanced risk return profile. Debt funds also tend to perform better in periods of economic slowdown. We believe that debt should be looked upon as an effective hedge against equity market volatility, which lends stability in terms of value and income to a portfolio. Some hybrid debt schemes take exposure in equities allowing investors to participate in the stock markets as well. As with any mutual fund, investors should look at factors such as performance track record over interest rate cycles, transparency and investment style consistency, before investing in a debt fund.

Are You Wasting Your Money in the Wrong Insurance Policy? Can You Get out of It?

Life insurance should be used only as a financial protection tool

for your loved ones dependent on you, NEVER to create wealth.

There are many investors who happily say they have 5, 7, 10 or even more life insurance policies and the maturity amount of each policy (usually 15-20 years later) is twice or thrice the total premiums that they will pay. They feel they have made a very savvy investment and it will help them meet all their financial commitments in life. They are usually concerned with only one question while buying these policies, “How much will I get back from it?” Do they know that most such policies actually give them returns in the range of 6-7.5% only!! Rarely do these policies go beyond this range. This is so because buying insurance for the sake of investments or savings for future is like trying to dig a well with a spoon – not that there is anything wrong with the spoon, but the purpose for which it is being used is absolutely wrong.

Insurance is a service purchased to replace any financial loss incurred by you due to any unfortunate event. For example, you can insure your car, house, health and property to replace the loss in the event of damage, theft, fire, accident, etc. You can similarly insure your life for the sake of those who are financially dependent on you so that in case something happens to you as the main bread-winner of the family, at least your family gets a decent amount of money to carry on with their basic requirements of life till they can stand on their own feet. Hence, the purpose of insurance is purely to replace a financial loss. Investment on the other hand, is what you hold, allow its value to grow at a smart pace and then sell for consumption in future. Hence, one always invests at the best possible rate of return to fulfill future goals such as children’s education, their marriage, purchasing a house, dream vacations or retirement funding – of course, all the investments have to be consistent with the amount of financial risk you are prepared to take.

It’s not at all a good idea to mix the two – insurance and investment !!

Let’s understand this by a simple example:

A and B, both aged 30, go to buy a life insurance policy for themselves. A opts for an endowment plan of 30yrs with a life cover of Rs 10 lacs at a premium of Rs 32,000 p.a. On the other hand B opts for a term plan providing the same life cover of Rs 10 lacs and the same term of 30 years but, at a premium of Rs 3,700 p.a. only.

Now, the difference between the term insurance and the endowment insurance is that term insurance offers only insurance, ie no money is paid if the insured survives the term, as it happens with your car or house insurance. However, in the endowment insurance plan, a maturity value is paid at the end of the term if the insured survives the term of the policy. Examples of Endowment Plans are the money back policies, children plans etc. A made fun of B by saying that latter has only ‘wasted’ his money buying that insurance as he will get nothing in the end. A felt proud that his endowment plan will provide him a maturity value of Rs 29,43,655/- (ie a return of around 7%). B explained to him that while taking a term plan, he was paying a premium of only Rs 3,700 p.a for the same cover of Rs 10 Lacs, hence saving the extra premium of Rs 28,300 that A paid (32000-3700). Now, this extra premium he plans to invest in equity Mutual Funds with an approx estimated return of 16%p.a. over the long period of 30 years. This is likely to earn him a whopping Rs 1,74,09,073/- compared to A’s endowment plan providing 7% p.a. returns and a maturity value of Rs 29, 43, 655/-!! Thus, B’s aim of getting a Rs 10 Lacs insurance cover and good investments on his money are fulfilled far better than A.

So, was it a right decision by A to choose insurance as an investment instrument? A resounding NO!

If you are still tempted to use insurance as an investment, please also consider that the monthly contribution made in investment avenues like Mutual Funds can be changed, whereas, the monthly premium for life insurance cum investment policies usually cannot be changed.

Another argument that goes against insurance for investment is that, due to using the wrong tool for insurance as also investments (remember, using a spoon to dig a well!), you neither get the Insurance as per your requirement nor are able to get the best out of investments properly. In the example quoted above, if actual requirement of insurance for A and B was 50 lacs each, B could’ve easily provided that much financial security to his dependents by taking a term plan for 50 lacs (for just about Rs 5000 more per year). Could A have gone in for such an insurance cover since he was trying to buy a khichdi of insurance and investment by taking an Endowment plan?

The question then arises is – are these endowment kind of plans good for anybody? Yes they are if you think you need to be forced to save – in insurance policies, you have to pay to pay your premiums, no way out since otherwise they will lapse. They are also good for you if you want to put in almost no effort into your investments and are ready for their low returns – because you would, otherwise, not do anything at all! However, if you are not prepared for low returns and are prepared to put in some effort towards your investments, then the combination of Term Plans (for insurance) and Mutual Funds (for investments) will work the best for you.

What do you do if you have any such undesirable insurance policies

Very often due to bad advice from a insurance broker motivated by his financial self interest you may get stuck with a bad insurance policy, which takes up too much of your savings leaving you with very little for meeting other bigger commitments. Here are three options available to the policy holders who intend to break free from a wrong insurance policy depending upon specific needs:

1. Surrender the policy after paying premium for the minimum cut-off period required to fetch the surrender value so as to get some money back. However, such amount will be a fraction of the total premium paid by you because of imposition of steep surrender charges by the insurer in the initial years, which progressively goes down as the policy progresses.

2. Convert your policy into a paid-up one by stopping payment of premium but without discontinuing it. It is considered a better option to turn a policy into a paid-up one than to surrender it and lose its life cover.

3. Allow your insurance policy, no matter how bad it is, to continue for its full term. If your policy is close to maturity, you should continue to pay the premium for the full period. When you have already passed through the difficult period of paying high charges in the initial years of the policy, it absolutely makes no sense to let go the built up benefits at the very end of the term.

What are your options in this increasing EMI scenario of your home & other loans?

Maj Manish is a 30 year old officer and his family includes his wife (homemaker), 3 year old daughter, and retired parents. Manish had taken a home loan of Rs 25 lakhs one year back at 8.5% for 20 years with a monthly EMI of Rs. 21696. Apart from repaying the home loan, Manish’s other goals include planning for his daughter’s education, marriage and his own retirement. However, his entire planning is going haywire with his borrowing bank raising his Equated Monthly Instalments (EMIs) frequently ever since he has taken the loan. In one year the interest rate on Manish’s home loan has increased from 8.5% to 10%. The EMI has shot up from Rs 21,696 to Rs 24,043 and the outstanding balance is Rs 24.50 lakhs. Against the original total interest outgo of Rs 13,67,754, now the total interest outgo on the loan in the next 19 years will be Rs 17,59,484 even after paying the 1st year interest of Rs 2,08,892.
Just like Manish, lot of other people are facing the same problem due to the increase in their EMIs. So how can people like Manish tackle such situations? What are the options available to people like Manish?
Reason for rising interest rates
Since the last one year, in its monetary policy announcements, the RBI has been constantly increasing interest rates (Cash Reserve Ratio (CRR), Repo Rate and Reverse Repo Rate) in its battle against the inflation monster. All this has increased the borrowing costs for banks over a period of time. Initially banks were able to absorb the rate hikes and shield their customers against increased EMIs. But banks cannot absorb the rising costs of funds all the time. After initially resisting increasing interest rates, banks started passing the rate hikes to their customers by increasing the interest rates on floating rate loans. Since the last few months, customers have been feeling the pinch of increased rates in the form of higher EMIs on home loans, auto loans and other loans.
Pre-payment of Home Loans
Banks allow customers to pre-pay loans. Pre-payment helps the customer to reduce the outstanding amount and thereby reducing the interest burden and also finishing the loan earlier than its normal schedule. Pre-payment can be done in two ways: pre-paying a lumpsum amount at a time or increasing the EMI (5% or 10% or whatever % the customer is comfortable with). Let us explore the two options.
Pre-paying a Lump sum Amount
If the customer gets a onetime cash flow, he can use that to make a lumpsum pre-payment and reduce the outstanding balance on his home loan. For example, in case of Manish, if he has maturity proceeds from a bank fixed deposit (FD) or National Saving Certificates (NSC) or insurance maturity proceeds or for that matter, any lumpsum amount available to him, he can use this amount to make a pre-payment and reduce the outstanding amount on his home loan. By making a pre-payment the customer has 2 options:
• Reducing the loan tenure: The customer can make a lumpsum pre-payment and reduce the tenure of his home loan and keep the EMI the same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a onetime cash flow of Rs 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs 5 lakhs, it will reduce his outstanding amount from Rs 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to keep his EMI same at 24,043 and reduce the tenure of the loan. In such a scenario the tenure of Manish’s loan will reduce from 19 years (228 instalments) to 11 years (136 instalments). Manish’s instalments will get reduced by 92 instalments.
• Reducing the EMI: The customer can make a lumpsum pre-payment and reduce the EMI of his home loan and keep the tenure same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a onetime cash flow of Rs 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs 5 lakhs, it will reduce his outstanding amount from Rs 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to reduce the EMI on the loan and keep the tenure same at 19 years. In such a scenario the EMI on Manish’s loan will reduce from Rs 24,043 to Rs 19,137 and the tenure of the loan will remain same at 19 years.
Increasing the EMI by 5%
Every individual expects his salary to increase by at least 5% or 10% every year. So the person can use this increased cash flow to lighten his loan burden. Manish can ask his bank to increase his EMI by 5% compounded every year. In such a scenario, Manish’s current EMI will increase from Rs. 24,043 to Rs. 25,245 and subsequently go on further increasing by 5% every year. In such a scenario, Manish will be able to service his loan in 130 instalments (11 years) instead of 228 instalments (19 years) and reduce 98 EMIs. Some banks do not allow the customer to increase the EMI. In such a scenario Manish can take the difference between the increased EMI (Rs 25,245) and original EMI (Rs 24,043), i.e. Rs. 1202, and put it in a monthly recurring deposit. The customer can then use this money to make lumpsum pre-payment at the end of the year. The customer can follow this practice every year till the loan gets over.
Increasing the EMI by 10%
Manish also has the option to increase his EMI by 10%. In such a scenario Manish’s current EMI will increase from Rs 24,043 to Rs 26,447 and subsequently go on further increasing by 10% every year. In such a scenario Manish will be able to repay his remaining outstanding loan amount in 8 years (100 instalments) instead of 19 years and reduce 128 EMIs. If his bank does not allow this increase in EMI, Manish can take the difference between the increased EMI (Rs 26,447) and original EMI (Rs 24,043), i.e. Rs. 2404, and put it in a monthly recurring deposit to make lumpsum pre-payment at the end of the year.
Points to Remember:
While the customer can always make a partial lumpsum pre-payment or ask the bank to increase the EMI on his loan, there are few things that he should keep in mind. These include:
• A customer should not use money reserved for other goals like child education, marriage, retirement etc for pre-payment of home loan.
• When a customer asks the bank to increase the EMI by 5% or 10% every year, then he should make sure that he will be able to service the increased EMI. For example, if the customer increases his EMI by 10% compounded every year, then after few years the EMI may become substantially higher and the customer may find it difficult to service it.
• To make the article simple to explain the article assumes that there will be no further rate hikes in future. But in case of floating rate home loans the rates may increase or decrease depending on the market direction of interest rates. Once the interest rate changes, all the above calculations will change.
Conclusion
We have seen above how customers like Manish can service their home loan in a better manner. A customer can:
Make a partial lumpsum pre-payment and reduce the tenure of the loan and keep the EMI same OR
Make a partial lumpsum pre-payment and reduce the EMI of the loan and keep the tenure of the loan same OR
Increase the EMI on the loan by 5% or 10% or any percentage that he is comfortable with and finish the loan before its normal schedule OR
Use a combination of partial lumpsum pre-payment and also increase the EMI every year by a certain percentage and finish the loan before its normal schedule.

The above mentioned all options are very flexible in nature and customers can use them depending on how comfortable they are with each of them