Deflate the Flat Interest Rate Initiative

Recently my friend received a call from ICICI Bank offering personal loan at 7.2% flat rate of interest per annum. Fortunately my friend was moneywise and he immediately understood the hidden meaning of a flat interest rate and turned down the offer.

In India, there has been a sudden spurt in reputed banks offering personal loans at Flat Interest rates. To the innocent consumer they offer an interest rate of 7% per annum at fixed interest rate. Since the borrower finds that this offer is much less than the ones offered by Housing Finance Company and he realizes that personal loans are riskier for the banks than Home loans, he gets duped to think that he is being favoured by this bank. While in reality since he will be returning the loan in equated monthly installments, he is actually paying almost twice the interest rate to the bank, on reducing basis.

To quote from "The Language of Money" by Edna Carew,

Flat Interest rate is the Interest charged on the full amount of a loan throughout its entire term and commonly known as a 'pre-determined' credit charge. The flat rate takes no account of the fact that periodic repayments, which include both interest and principal, gradually reduce the amount owed. Consequently the effective interest rate is considerably higher than the nominal flat rate initially quoted.
Anyone confronted with a flat rate of interest should remember: a rough rule is that 9 per cent flat equates to about 17 per cent effective per annum, ie, double the flat rate less one per cent, although this varies with the term of the loan.

So the next time when you get a call from a bank offering a personal loan at a low flat interest rate just remember it is a sales gimmick to hide the extraordinarily high rate of interest that will be charged to you. I consider this initiative to be just an unethical practice to fool and lure borrowers.

Build a Cash Reserve for Emergency

When my father was working, he never worried about job security as his was a government job and it still is assumed to be the most secure job to have in India. Most of his friends were also in government jobs and we friends always thought that as kids that after studies we will join a job and continue there till retirement.

With globalization and privatization, and less and less government/semi-government jobs available in the the country in open category, we have no option but to either join a private company, or be self employed if we do not have a business. In private job - there are old economy companies and new economy ones like IT, Telecom, Financial Services and others. Moreover, there are multinationals some of them do not think twice before closing its operations in India if business is not growing as expected or if there is a change in India specific policy.

While new economy companies give higher salaries, higher annual increments, and higher career growth opportunities, they are also not tolerant to a dip in performance. There can be several reasons because of which a persons performance may drop - indisposition to self or in family, soured relationship with spouse, or some other family discord. Such conditions can result in the unfortunate outcome - "pink slip".

Getting a new job can be difficult and time consuming specially when you do not want to compromise and want an equivalent or a better job. This can sometimes take 6 months or more.

How do you support your family in this period? - Once this situation comes unexpectedly, you are left high and dry; dependent on your friends and relatives. Unless you are prepared for such emergencies.

Planning for Emergency

In order to plan for such a situation, you need to first compute you must-do expenses each month. I have tried to enumerate some expense heads which are mandatory for a anyone.

S. No.	Expense	Amount per month
1	House Rent or House Loan Repayment (or both)	Rs. 10000
2	Groceries	Rs. 7000
3	Electricity and other utility bills	Rs. 1500
4	Child Education Expenses	Rs. 2500
5	Any other loan (Example - Car Loan)	Rs. 7000
6	Minimum payment on credit card	Rs. 1000
	Total	Rs. 30000

In the above example, I have assumed that you have a sufficient medical insurance for self and family. Else please incorporate the same in the above calculation. It would be a better idea to buffer this figure with Rs. 20000 a month for medical expenses because medical insurance only covers the hospitalization and operation expenses and not the recurring and associated expenses that come with it. That makes your monthly cash requirements to be Rs. 50,000.

Now that you have computed the minimum expenses which are must-do and cannot be avoided. Find out for your own special situation (the type of job you are in, and the environmental factors that govern the industry/domain you work in), how many months of cash reserves you should have. At the very least, the emergency cash reserve should be sufficient to cover up to six months of above expenses i.e. Rs. 3 lakhs in the above example.

Investing your Cash Reserve

There are three options to maintain the accumulated cash reserve -

1. Savings Account
2. Fixed Deposit

All these options provide you liquidity (money can be withdrawn whenever required). You do not want this money to be invested in any risky investment.

The simplest option is to put this money in a Savings Account. If you are also keen on some safe returns, my advise will be implement what is technically called laddered investment of reserve explained below:

Go to your bank (should be one of the front line banks and not like United Western Bank - you do not want to end up in a situation when you cannot withdraw more than Rs. 10000 in 3 months when an emergency occurs) and open 6 fixed deposit accounts (all on the same date) in the bank as follows:

FD No.	Maturity	Amount in Indian Rupees
1	30 days (1 month)	Rs. 50000
2	60 days (2 months)	Rs. 50000
3	90 days (3 months)	Rs. 50000
4	120 days (4 months)	Rs. 50000
5	150 days (5 months)	Rs. 50000
6	180 days (6 months)	Rs. 50000

As each fixed deposit matures extend it for another 6 months without withdrawing the gains of interest from it. Keep on repeating this process for all subsequent months and all subsequent cycles till the time emergency strikes. My friend who has made an emergnecy cash reserve of Rs. 6 lakhs calls it rolling FDs.

The reason of intelligently investing your reserves (by the above technique) is that emergency can occur today or it can occur in future, say 3 years down the line. At that time you want your cash reserve to keep pace with the inflation else you will fall short of meeting your expenses.

In case you borrow further loan after setting up the case reserve, you will need to back it up with supplementing your cash reserve.

Suppose you borrow a loan which demands Rs. 10000 of EMI per month - Just supplement your cash reserve by Rs. 60000 and invest it in 6 Fixed Deposit of Rs. 10000 each as explained above.

In case you feel that you need to create a 12 month reserve. Please go ahead and do it - only in that case you will need to open 12 FD Accounts with maturities from 30 days to 360 days as explained above.

Happy Investing !!!

Wealth Creation Mantra - Learn to Differentiate between your needs and desires

For those of us (including me) who are not born with a silver spoon, wealth creation for leading a happy, peaceful and secured life after retirement is a life long struggle. In good old days of my father, he used to feel secure because of his secured government job, and because of his assured pension.

Thanks to the government of India and its reservation policies, very few people are in a pensionable job these days. Moreover, the pension amount is not sufficient to maintain the same lifestyle for the two old people after retirement. The perquisites of the government job are no longer there post retirement and with old age people generally keep that well.

It is important to save from your earnings as much as possible and invest the savings intelligently to achieve independence from financial worries for life.

One important technique is to differentiate between your needs and desires and though needs need to be fulfilled, control your expenses on desires. Money thus saved can be used to provide that critical additional thrust towards achieving your financial targets.

While working for my earlier employers, who used to be nominating me for one training or the other, I came across a facilitator (Yes, he used to say, "I am not a teacher, I just facilitate your thinking") who gave me this gurumantra.

The participants asked him, "How to differentiate between your needs and desire?" He gave a very simple example to help us differentiate - "You drink water to satisfy the need of thirst, but you drink Pepsi to satisfy a desire, you actually do not need it".

I will not advise you to totally stop fulfilling your desires, lest you start feeling that life is worthless, but try to restrain them and achieve a substantial cut in fulfilling them. The money thus saved can be effectively invested to contribute to your retirement kitty.

I hope you are not wondering that how much such small amounts make any significant contribution. Let us take the example of my friend Deepak who consumes 10 cigarettes a day since he was 21. He is now 38, meaning he has spent Rs. 300 a month for the last 17 years. Suppose, he had invested this amount and not fallen for this useless habit, and earned a modest 15% a year on this investment, he would have accumulated Rs. 2,34,000 and if he continues with this till his retirement he would accumulate Rs. 42 lakhs, besides the cost of any health hazard caused due to smoking. Twenty years from now, Rs. 42 lakhs will be equivalent to Rs. 9 lakhs of today (considering an inflation rate of 8%).

Now just do a quick calculation - Just imagine that you are retired today, and there is no one in your home but just the two of you (husband and wife), your children are settled, your house is free of loan, you are free of any old age disease. How much money will you need per month to live a decent living - My guess is Rs. 20,000 per month. How long will this Rs. 9 lakhs support you? - The answer is 45 months or approximately 4 years.

Just imagine - Just letting go of your desire has the potential to support you for 45 months and you are less prone to all the diseases which come along with it.

I am signing off as I need to do some serious thinking about my smoking. Happy Investing !!

My First Investment: A true life story

After completing my engineering and coming on tops in the university, I started working as a Lecturer in my engineering college. Teaching was my first choice and I took it preferring it over better jobs like NTPC and BHEL. When we were staying in the transit accommodation provided by my college, I had a friend staying with me as a guest. This friend of mine worked in one of the leading manufacturers of Electrodes in India.

My friend Anil, had colleague whose part time job was to sell insurance products for Life Insurance of India as an insurance agent. This insurance agent Ramesh, was working as the EA to their VP-Sales in the electrode company. The reason why he was successful as an insurance agent was because all the sales engineers across India bought insurance products from him to remain on his good side. The hidden advantage was that Ramesh will help them with insider information affecting them and their department and also help them in clearing their re-imbursement bills.

For these aforesaid reasons, Anil wanted to buy an insurance from him, and because he was going to visit us on a Sunday, Anil also wanted me to preferably buy one insurance cover to help him be closer to the Executive Assistant than his other peers.

So Ramesh, visited us on the Sunday and after suggesting an insurance for Anil and taking his cheque, he turned on me.
“What is your age?”, he asked me.
“I will turn 22 this June.”
He took out his diary having a look at some table he had, he suggested, “Manoj you should go for a money back policy.”
Since I was very new to the concept of insurance at that time and the only thing I knew was that my father did have some insurance, I asked, “What is money back policy?”
“In money back policy, besides the lump sum amount you get at the end of the insurance term, you also get a part of the bonus as fixed payments every five years”, Ramesh explained. He explained how buy just paying Rs. 1002 half yearly for next 25 years, LIC will cover me for Rs. 50 grands and pay me Rs. 7500 in the fifth, tenth, fifteenth and twentieth years.

Ramesh also revealed, “Manoj you can actually make Rs. 5,00,000 by just investing just about Rs. 50,000 and that too spread over 25 years.”

Now this was something very exciting. This statement definitely activated my antennas and I was definitely interested in his proposal.

He explained that every year LIC declares bonus for such policies to tune of Rs. 60-70 per thousand. For example last year it declared it at Rs. 64/thousand, what this means is that last year a bonus of Rs. 3200 would have been credited to my policy account had I bought it last year.

Then he drew the following table for me:

	Fifth Year	Tenth Year	Fifteenth Year	Twentieth year
Fifth Year	7500
Tenth Year	15000	7500
Fifteenth Year	30000	15000	7500
Twentieth year	60000	30000	15000	7500
Twenty Fifth Year	120000	60000	30000	15000

Those days in 1990, the rate of interest on post office fixed deposits was approximately 13%. What I knew was that those days money doubles in 5 years. This table drawn by Ramesh was actually depicting that if I re-invest all the money given back by LIC without taking them in the next 25 years, the total amount accumulated is the sum total of all the amounts written in the above table.

If you sum them up it comes out to a whopping Rs. 4,20,000. Add to this the total amount put by me and bonuses accrued to me in 25 years. It totals to Rs. 1,10,000 by totaling the amount paid to LIC in 25 years and the bonus minus the money received back from LIC in each 5 years. So the total returns in 25 years, will be more than Rs. 5,00,000.

Now that I know how to compute the annual returns of this investment, I know that this amounts to XXX % return per year even if we assume that the whole Rs. 50,000 is invested in lump sum at the start of the 25 years. This return is very good considering that the money invested in LIC is deployed in safe investments and also this investment carries an insurance of Rs. 50,000 which costs money to LIC. Moreover, investment in insurance was tax free to the tune of 20%, and the promised return at the end of 25 years was also tax free.

Actually I was not supposed to invest in a lump sum but distributed over 25 years @ Rs. 1002 per six months, the annualized return of this investment comes out to be an attractive 16% which is better than the rate at which the stock market has grown over the last 10 years.

What are your views on this investment, dear readers? Does it look too good to be true? Do you think I was able to generate the promised returns? If not, was Ramesh at fault? Was he trying to promise me more than what I could achieve?

Today, after fifteen years of subscribing to this insurance policy and having paid 30 half-yearly premiums and taken the money back thrice, I am no where close the Rs. 5,00,000 mark or even half of it. I am also sure that I will be nowhere close to half of 500K after the tenure is over i.e. after 10 year.

Whose fault is it? Mine or Ramesh’s?

There are 2 reasons why I was not able to reach the financial goal which was sold to me at the start of this investment:

For a long number of years before 1990 when I made this investment the prevailing rate of interest was more than 12%. Hence, Ramesh believed that it will remain so in future, he never imagined that it will not be so. I too believed in him for similar reasons. For years I had heard from my dad and read in newspaper ads, that money doubles in 5 years. Unfortunately for me and for my investment, the rate of interest in government securities have dropped continually from 1991 till date and now it takes more than 12 years for the money to double.
The other reason is totally my fault. That of lack of financial discipline. The first money back investment was utilized in buying a refrigerator on the birthday of my wife when we were courting each other. The second installment was spent for ‘I-do-not-remember-what’. The third installment is lying in a saving bank account of ours earning us a return of 3% per annum.

Rule of 72 - How many years to double your money?

Have you ever been in a situation where you are required to immediately decide upon an investment decision, without access to a computer or a financial calculator. Rule of 72 is a time tested rule of thumb to find out the answer to the question - How much time will it take to double my investment at a given rate of return? The actual mathematical computation of this is very cumbersome and beyond reach of common man without Microsoft Excel. It is a very handy and lightening fast benchmark to determine how good or not so good a potential investment is likely to be.

The rule of 72 works like this.

To compute the Number of Years required to double the amount you have to invest just divide 72 by the rate of return and lo and behold you have the Number of years required.



As an example, when I started my job, the rate of return offered by my bank was 12% and hence by rule of 72 I could compute that it will take 6 years for my fixed deposit to double. (which is a close approximation of 6.12 years which it actually took). Rule of 72 is an approximation which works well as long as the rate of return is below 28%, beyond which the error increases.

The Rule of 72 can be applied to compute the rate of return required to double my money in a pre-determined time frame. Suppose I want to double my investment in 3 years, I need to find out an opportunity which gives me (72/3=) 24% rate of return.

To further understand the Rule of 72, consider the case of Deepak who borrowed from a money launderer Rs. 1,00,000 to meet certain emergency at a whopping 36% rate of interest. He was unable to re-pay even a single penny to the "seth" for two years. When he visited the seth two years later, he found that he now owes Rs. 2,00,000 (=72/36) to the seth. No wonder you read a lot of incidences of farmers committing suicides because of spiraling loans and harassment from money launderers because of non-return of loans.

Rule of 72 (which is a simplification of compounding) works in your favour when you invest money and works against you when you when you borrow it.

Happy Investing !!