How To Build Your Wealth With A Loan

Personal Finance debt, i.e. taking a loan, can be a great tool to build your wealth.

Loans can offer you many benefits, for example home and car loans help you achieve the financial goal of buying a home or a car (by making payments over a period of time) without having to wait and save enough to make an outright purchase.

However loans are often misconstrued as an instrument for the non-wealthy, when this is indeed not the case. Wealthy investors often use loans to help themselves get even wealthier. Where loans are concerned, you might find that you are one of two broad types of individuals. Each type has a unique viewpoint when it comes to taking a loan.

First, there are the emotional extremes - those individuals who either dislike loans so much that they will not borrow even a rupee, or those who like loans so much that they have over-leveraged themselves and might be now struggling under their EMI burden.

Second, there are the 'I'll Take It, But I Won't Like It' individuals. These are the ones that take a middle approach when dealing with their liability. Once they have taken the loan because they need it - the logical step, they then do their best to repay / prepay it as quickly as possible because of the mental or emotional discomfort caused by being 'in debt'. Most of us find ourselves in this second category.

The simple truth of the matter however, is a very factual truth.

A loan is simply the borrowing of funds, to be used for a particular purpose. Loans will simply give you the opportunity to incur the expenditure (for example, buy the house or the car) that you wish to incur, when you wish to incur it, and repay the amount a little at a time every month, over a specified tenure.

In this article, we will cover 2 aspects to personal finance debt.

• Different Kinds of Loans Available, and How to Ensure You Don't Over-Borrow
• Why it is sometimes Not better to prepay your loan
  

Different Kinds of Loans Available and How to Ensure You Don't Over-Borrow

Unsecured Loans
An unsecured loan refers to any kind of loan that is not attached by a lien on any of your specific assets. This means that in case you default on the loan due to bankruptcy or any other reason, the unsecured debt lender does not have the right to claim any specific asset.
An example of this is credit card debt or perhaps a personal loan from a friend or relative.

Secured Loans
A secured loan is one where you, the borrower, pledge some asset of yours as collateral to the loan. This means that in case of bankruptcy or any other reason for defaulting on the loan, the lender of your secured debt has the right to take possession of the asset (known as repossession) , and sell it to recover some of his loss.
An example of this is your car loan and home loan.

There are many options of loans and different lenders (from banks to housing finance companies to your relatives), which can help you take a loan when you need one. You need to ensure however that you don't over-borrow and put a strain on your finances. There is a simple way to check whether you are over-leveraged or not.

It is the Debt to Income Ratio.

                                                 Total monthly outgoings on liabilities (EMIs)
Debt to Income Ratio =               Total monthly income from fixed sources

As discussed, this ratio is simply the sum of your monthly outgoings (EMIs) on your liabilities, divided by your total fixed monthly income. It ideally should not be more than 0.35 (or 35%), else you may be putting a strain on your income to service your debt.

Before taking a loan, assess your monthly income and expense, see how much additional outflow you can afford to have on an EMI, and accordingly decide how much loan you can comfortably handle.

Remember, if you take a higher loan, you have to pay a higher EMI. The broad thumb rule is, your EMI will be as many thousands per month, as every 1 lakh loan you take.
So, if you take a loan of Rs. 20 lakhs, your EMI will be (approximately) Rs. 20,000 per month.

Why It Is Sometimes NOT Better To Prepay Your Loan 

At PersonalFN we have come across many clients, who once they have taken a loan, prefer to prepay it as soon as possible because the idea of being 'in debt' is not comfortable for them.

This is a personal matter and while there is no question that these clients are genuinely feeling uncomfortable about the loan - it does not necessarily make financial sense to prepay as early as possible.

The reason is simply the opportunity cost of your money.

This means, if you have a loan which is charging you interest at 10% p.a., and you suddenly come into some surplus funds which you can either use to prepay all or part of your loan, or to invest, the first thing you need to do is check the opportunity cost of these surplus funds.

Would it make more sense to prepay the 10% interest loan, and thereby save yourself from paying the 10% interest? Or would it make more sense to invest the funds into an investment instrument that would earn you more than 10% - based on your risk appetite and time horizon?

For example, Mr. Shah (our favourite fictional character) has taken a home loan on which he is paying 10.50% interest currently. He has recently inherited Rs. 10 lakhs and wants to use it to partly prepay his loan. As there is no prepayment penalty any longer, he wants to prepay the loan up to Rs. 10 lakhs - the entire extent of the inheritance.

However, instead of prepaying the loan, if he invests the Rs. 10 lakh into a strong performing diversified equity mutual fund, then in the long term (3-5 years plus) he will likely earn a return of 15% per annum on this investment. So instead of saving 10.50%, he is earning 15%.

This is what we mean by opportunity cost. If he chooses to prepay the loan and save 10.50% interest, he is losing out on the potential earning of 15% return.

Remember, if there is an investment instrument which would give you a long term rate of return that is higher than the rate of interest you are paying on your loan, it would be financially more prudent to invest the funds and earn the higher rate of return, than to prepay the loan (in full or in part) and save yourself the lower rate of interest.

In addition, certain loans have tax benefits. For example, a home loan on a self occupied property helps you get a tax benefit of up to Rs. 1 lakh on principal repayment u/S 80C and interest repaid is deductible up to Rs. 1.50 lakhs. On a let out property, the interest deductible is not limited, you can claim full interest paid as a deduction from your annual taxable income.

So, remember - a loan can be a great tool to help build your wealth. Just remember to only take the amount of loan you are able to service without adding financial stress, and have a contingency fund set aside as well.

How To Use Infra Bonds, HRA, LTA, Home Loan To Save Tax

It's that time of the year again! When everybody's in the holiday spirit, you might be taking a family vacation to reward yourself after a long year's work, and let's not forget – this is also tax-saving time.

If you are a salaried individual, your company is probably going to ask for your investment proofs for this year right about now. Most people stop at giving proof of their Section 80C investments. But there are a few more things that you can consider. Let's see what these are.

1. Infrastructure Bonds: Section 80CCF
   
   You must have seen the hoardings lately. IDFC, IFCI and other companies are advertising their infrastructure bonds, which give you tax relief under Section 80CCF and enable you to in your own way, contribute towards building the infrastructure of the country.
   Investments of up to Rs. 20,000 in these bonds qualifies for tax deduction.
   These bonds are launched by companies including IDFC, L&T, IFCI, IIFCL and other NBFCs classified as infrastructure companies.
   
   If you are in the 30.90% tax bracket, then investing in an infrastructure bond will save you up to Rs. 6,180 this year. With this tax amount saved, the yield on these bonds goes up significantly. This is a definite consideration from a tax saving point of view. For more details on which infrastructure bond to invest in, do have a look at our article on REC Infra Bond - 80 CCF . You have until March 31st, 2011, to invest in any infrastructure bond, but do note that the interest rate offered right now is quite attractive, and will most likely not get any higher than it is right now, so don't wait.
   
2. Save tax through your home loan (Section 80C, Section 24) 
   
   If you have a home loan right now, you're probably feeling the pinch of the high interest rates through your EMI. But, there's a beautiful silver lining to your home loan, and that's how its helping you save on tax.
   
   The laws of our country are such that if you have taken a home loan on a house that you are living in i.e. a self occupied property, you are eligible for a Rs. 1 lakh deduction under Section 80C on the principal repayment of your home loan, and a Rs. 1,50,000 deduction under Section 24 of the interest repaid.
   
   But, apart from this, if you have taken a home loan on a house that you have given out on rent i.e. a let out property, then your tax benefits are much higher! You get the same principal deduction as a self occupied property, but here your interest repaid is fully and completely deductible! There is no limit on interest repaid on a let out property.
   
   Make the most of either of these 2 situations and you can save a hefty amount of tax, which you can promptly invest towards your retirement. For more information on this, do check out our tutorial on Saving Tax through House Property.
   
3. Know how to use your short term capital gains loss
   
   If you, like most investors, also trade in shares, and have made some losses this year, you can set off these losses against any gains that you have made.
   
   The divisions are as follows:
   Short Term Capital Loss can be set off against Short Term Capital Gains, or Long Term Capital Gains. Long Term Capital Loss can be set off only against Long Term Capital Gains. So For example, if you have made a short term capital loss on direct equity, and made a gain on Gold ETFs or even physical gold, or perhaps a gain made on property, you can set off the losses against the gains. Please do speak with your CA for more details on this as the rules are very specific, and save more tax this year.
   
4. How to save tax through salary allowances i.e. HRA, LTA, Medical Expenses
   
   If you look at your salary slip, you will see certain amounts each month stats as HRA (House Rent Allowance) and LTA (Leave Travel Allowance).
   
   These sub divisions in your salary are there to help you save tax.
   If you are living on rent, then you can claim HRA by showing your rent payment receipts. Remember, the HRA rules allow you to claim only a certain amount of HRA which is the least of the following:
   
   
   1. Rent paid less 10% of your basic
   2. 50% of your basic (if you live in a metro) or 40% if you live in a city other than a metro
   3. Actual HRA received
      
   This is an excellent way to save tax. So if you are living on rent, you must use it.
   
   Similarly, your LTA allows you to save tax as well. If you have taken a holiday or plan to take a holiday before March ends, you can claim your travel expenses (only travel, not stay and food) within a limit as set by your employer and within certain rules as set by the Government of India. For details on how to save tax using LTA, please see our tutorial on How To Save Tax in your Salary.
   
   Everybody has medical expenses and what's great is that you can use these regular medical expenses to save tax. This depends on the salary structure decided by your company. Some companies offer a reimbursement of medical expenses up to Rs. 15,000 per year. Others include it as a part of your salary structure which you receive every month, and you can present bills up to Rs. 15,000, which will be tax deductible under Section 17(2). 

Should You Pay a Higher EMI on your Home Loan?

This article is based on a query we received on whether or not it is advisable to pay more than the EMI amount back every month on the home loan, so as to reduce the tenure of the loan and become free from debt faster. Let’s see how the case pans out.

Let’s call this person who wrote to us Mr. A.

Mr. A has taken a home loan of Rs. 10 lakhs from bank at the rate of 10.50% p.a. for 20 years on monthly reducing balance basis. His EMI is Rs. 9,984 but because he has surplus of Rs. 5,016 per month he can increase his EMI to Rs. 15,000. Now he has 2 options, either he can increase the EMI or invest surplus amount in combination of Equity Mutual Funds and Debt Mutual Funds on which he can get approx. 10% p.a.

Which option should he choose?

In order to decide whether to increase EMI or invest surplus amount, we have to do some number crunching…

Option 1 - Increasing EMI

If Mr. A decides to increase his EMI from Rs. 9,984 to Rs. 15,000, he will be able to pay off his loan in 101 months i.e. 8.42 years instead of 20 years.

In the remaining tenure i.e. 139 months amount of Rs. 15,000 can be invested at 10% p.a., it will give him Rs. 38,22,945.

Option 2 - Investing Surplus

If Mr. A decides to invest surplus of Rs. 5,016 p.m for 20 years at the rate of 10% p.a. he will get Rs. 36,31,517.

Note: We have not assumed any tax savings on interest paid for home loans.

Comparison:

Option	EMI	Loan Completed in period (Months)	Investment	Investment Rate	Tenure of Investment	Future Value of Investment
1	15,000	101	15,000	10.00%	139	3,822,945
2	9,984	240	5,016	10.00%	240	3,631,517
Excess value of investment by increasing EMI						191,428

• If we compare both the options we can analyse that in the 1st option loan is prepaid in just 101 months while it will take 240 months to pay off the loan if he doesn’t increase his EMI.
  
• Since the loan is paid in just 101 months in option 1, Rs. 15,000 can be invested for the remaining tenure of 139 months (240-101) at 10% p.a. which will give him Rs. 38,22,945 at maturity which is Rs. 1,91,428 more than option 2.

In such a scenario Mr. A is better off in Option 1 which is increasing EMI to Rs. 15,000.

But what if the rate of return on his investment changes?

Let’s assume investment rate of 12% p.a. instead of 10% p.a. (everything else remains the same)

Option	EMI	Loan Completed in period (Months)	Investment	Investment Rate	Tenure of Investment	Future Value of Investment
1	15,000	101	15,000	12.00%	139	4,334,677
2	9,984	240	5,016	12.00%	240	4,614,004
Excess value of investment by Investing Surplus						279,327

If we analyse it carefully we can see that just by changing the investment rate from 10% p.a. to 12% p.a. Mr. A’s decision regarding increasing EMI changed to investing the surplus amount because it is giving him higher maturity amount by Rs. 2,79,327.

Why did this happen? 

In the 1st scenario his investment rate is less than his rate of interest being charged on the loan which means he is earning interest on investment at lesser rate while paying higher interest on his loans, so its better to increase EMI and pay off loan ASAP.

In the 2nd scenario his investment rate is more than rate of interest charged on the loan which means he is earning interest on investment at higher rate while paying lower interest on his loans, so its better to invest surplus amount.

By now you might feel that all the calculations involved here are too much complicated, but do not get carried away by this. All you need to do is remember 1 simple rule: If you can earn higher rate of return on investment than what you pay as interest on loan, it would be always be better to invest the surplus amount rather than paying higher EMI. 

Why is insurance important to your financial health?

What is insurance?

Insurance in its purest sense is protection against a financial loss / uncertainty which includes the risk of illness, disability, damage to property, and the most final of them all - one's demise.
The value of your loved one's life is a very sensitive issue as your loved ones are priceless. But it becomes necessary to evaluate a human life in terms of money, in order to safeguard from problems caused by under-insurance.
Human Life Value (HLV) of an earning member in the family could be defined as the amount that the family would require to retain the same standard of living in the absence of the earning member. This would be the maximum amount for which a person can seek insurance protection. The amount of insurance you require can be calculated in a few different ways -but a comprehensive method of calculating this is the PersonalFN's HLV method. 

How to calculate HLV
The first step towards calculation of HLV would be to determine the net annual income of the person after deducting the amount spent by him for his personal use. This amount will be the amount that he affords to his family annually. For Example: Mr. Sinha, aged 40 years, earns 15,00,000 per annum and spends  4,50,000 per annum on himself. Hence, he earns a net income of 10,50,000 p.a. for his family. Therefore, as income replacement, his family would require 10,50,000 p.a. for 1 year of life expenses. Each year, with inflation, the family's expenses would proportionately increase, which must also be taken into account.
The calculation will also include specific goal related expenditure. For example, suppose Mr. Sinha has a son and a daughter both of whom would require  10 lakhs for their educations i.e. a total of  20 lakhs. In Mr. Sinha's absence, this amount is still required such that the children's educations do not suffer. Hence this goal amount can be added to the financial value of Mr. Sinha's life.
Once the HLV has been calculated, the next step is to choose the appropriate insurance product to cover your needs. There are a number of insurance products available in the market today - from term plans to ULIPs to endowment plans and so on. It is important to assess the available products and select the right insurance for your needs. At PersonalFN - we recommend opting for pure term plans.

Term Plans A term policy is a simple pure life insurance which provides a sum assured in case of the policy holder's unfortunate demise. Most people are not in favour of a term policy, as there is only a death benefit. Also, it is believed that since the insurance is available only for a particular term after which there is no cover, it is not a comprehensive policy. But the reality is that term policies are the purest form of insurance available today. They are very cheap compared to otherinsurance policies.

Endowment Policies These are traditional policies floated by Insurance companies. An endowment policy covers risk for a specified period, at the end of which the sum assured is paid back to the policyholder, along with the bonus accumulated during the term of the policy. The returns on endowment policies are typically very low - approximately 3% to 4% per annum - and often do not beat inflation.

Unit Linked Insurance Plans These are insurance policies with an investment component. In these policies, the policy holder pays premiums (or a single premium) of which part of the money is invested and another part goes towards providing the life insurance cover. ULIPs therefore combine insurance protection with wealth creation opportunities.

What should you opt for? 
It is recommended to always opt for a pure insurance product rather than combining insurance with investments such as what is done by way of marked linked insurance policies i.e. ULIPs etc

Also, it is seen that traditional policies such as endowment policies and money back policies provide very poor returns, giving a yield of 3 to 3.50% per annum over the entire term. This does not even match inflation and hence it is not recommended to take these products. Products like ULIPs and the like have hidden charges and high commissions, which lead to an inefficient use of your funds which could otherwise have been invested. Until these products become transparent, it is not advisable to opt for them. At PersonalFN, we believe taking a straightforward term policy is the best insurance you can take. It is also advisable to opt for the following policies, in addition to your term policy:

• Health Insurance (Mediclaim) - this is a must have for every family member. It can be taken as an individual policy or as a family floater. This will cover regular hospital expenses in case of any hospitalization.
  
• Personal Accident Policy - this will cover you from loss of income in case of an accident. This is a common policy for those who are employed as the policy partly covers you from loss of income.
  
• Critical Illness policy - this will pay out a lump sum upon diagnosis of any critical illness from the defined list of illnesses stipulated. This policy can be opted for by any member of the family - it is not meant only for people who are employed as a critical illness might strike anyone, and costs incurred in case of such illnesses can be very high.
  Conclusion

It is advisable to opt for insurance because it is a cover from risk - and while you might believe that something will not ‘happen to you' - that is often exactly what your neighbor is thinking. In case of an unfortunate circumstance, insurance can be a financial boon to you or your family members.