Debts are a reality of our financial life. Intelligent use of debt can increase our net-worth, whereas irresponsible use can bring our financial situation to knees. In this post, we will look into what kind of debt can be considered good and should be availed and which ones should be avoided.
Before we go further, let us understand that buying something taking a loan is using our future income to buy things today. This concept will help us decide whether to use debt to fund some purchase.
WHEN DEBT CAN BE CONSIDERED GOOD?
Most people simply cannot fund a house or a car themselves and they have to allocate part of their future income for the purchase in the form of debt. The purchase of the house or the car can improve our quality of life significantly and can increase our net worth. So, how could a purchase affect our net worth?
Let us consider some factors-
1. Will the asset funded by debt generate enough income with satisfactory predictability (or save expenses) to cover the debt payments (at least the interest part of the debt)?
2. Will the asset increase in value or lose value with time? Will that increase in value increase or decrease your equity in the asset?
In most cases, the lender will ask some portion of the purchase price be funded by the borrower. This is the equity position for the borrower.
The purpose of this point is to help us understand that certain assets have terrible resale value and certain assets can actually gain in value with time.
3. What kind of tax benefits will the interest payments provide? Will you be able to use the tax benefits completely?
When most of the answer to the above questions is yes, that debt can be considered as good. The factors influencing the above considerations are the interest rate charged, how the debt is being used, if the debt is being used to buy asset then will the asset gain in value in future and the tax benefits.
Going back to the concept that using debt to buy something is using future income to buy things today – a good debt increases future income enough to overall increase our net-worth.
WHAT IS A BAD DEBT?
Straight out of the bat, any debt which does not create an asset (future income or savings) is bad debt. Credit card debts, other personal loans and payday loans etc. fall into this category. Unfortunately, these debts often charge the highest interest rates and complicate our financial situation.
Any debt to cover lifestyle expenses should be considered as bad debt. More important than the source of debt is how the proceeds are being used.
Going back to the concept that using debt to buy something is using future income to buy things today – a bad debt does not improve future income.
One of the fundamental requirements of financial planning is separating needs from aspirations. People often confuse between their needs and their aspirations which results in poor financial planning.
HOW MUCH YOU NEED? – CORE CAPITAL
Core capital defines the amount of assets you need today to pay back all liabilities, fund future cost of living plus a reserve for an emergency.
It is the liabilities side of your personal balance sheet. To calculate the Core Capital we need to make assumptions about the mortality of you and your family, how your living expenses will increase with time, how expenses can increase apart from due to inflation etc.
Another assumption we need is that the assets we allocate as Core Capital will grow at a risk-free rate. This is an important assumption because we simply cannot take a risk with the assets needed to cover the basics of life.
Also, we need to decide a sufficient safety reserve which can cover emergency expenses such as medical expenses etc.
EXCESS CAPITAL – FUNDING ASPIRATIONS
The assets excess to cover for the Core Capital is the Excess Capital. These assets can be used to fund aspirations such as visiting exotic places or bequests.
WHY IS IT IMPORTANT TO CALCULATE CORE CAPITAL?
The first and foremost reason to calculate Core Capital is to understanding that not all our financial goals are the same. Some financial goals such as being able to maintain the current lifestyle, healthcare and education of children must take precedence over world tour or other aspirational expenses.
The second reason is to clearly separate assets and investments for covering basic needs as in Core Capital and assets and investments for aspirations. It is important because the risk tolerance for the Core Capital is much lower than the excess capital. It is better to create separate portfolios for Core Capital and Excess Capital as Core Satelite portfolio where the core is with comparatively low-risk assets such as fixed income and index funds and the satellite with assets seeking alpha.
The third reason is the practical reality that most people in India do not have enough assets to fund Core Capital needs especially in their youth. Calculation of Core Capital needs to help them understand this financial reality and avoid distractions of aspirational expenses when they are not financially ready to afford them.
Say you are planning to buy an apartment or a car and will have to take a loan for that. You did a CIBIL score check as your bank suggested and found that your CIBIL score is below 750 which is considered a bad CIBIL score.
A bad credit score may mean an inability to get loans. Even if lenders agree to give loans they will charge a high-interest rate. This high-interest rate gets translated to higher EMIs and the longer repayment period.
In this post, we will look into how we can improve our credit score.
But before that, learn what is a credit score-
POSSIBLE REASONS FOR A BAD CREDIT SCORE
1. Inaccurate Information in the CIR
CIR stands for Credit Information Report which contains details of your credit history and track records of availing and repaying credit. It is least to say that an accurate and updated CIR is fundamental to a good credit score.
2. Missed payments
Some of the missed payments may be caused by genuine financial hardship but also can be a result of operational issues such as non-receipt of statements or dispute over fees on credit cards. Also one can miss payments due to international relocation.
SO, HOW TO IMPROVE THE CREDIT SCORE?
1. Know your Credit Rating and Credit History
You cannot improve what you do not know. Get hold of the CIR and understand what contributed to your bad Credit History. Look for inaccurate information and information which requires to be updated.
You may find that some loan accounts which are supposed to be closed after you paid back the loan are still open. You may also notice loan accounts which do not belong to you.
There can be discrepancies with the account statement. A “settled” or “written off” status affects your credit rating negatively.
Also, check for discrepancies in the payment dates and due dates.
2. Raise dispute in case of inaccurate information
Credit Rating agencies have systems to raise disputes with them. In case the CIR is not updated with the latest information, get the latest statements from past lenders and submit them to the Credit Agency.
3. Handling past defaults
Whatever the cause be for past defaults, it is a better idea to pay past dues and settle with the lender.
CIBIL Dispute Resolution
Consider you have a loan with a considerable outstanding balance. Now, you came across loan offers with lower interest rates and better features. Another situation can be that when you took the loan you decided a shorter tenure but now your financial circumstances have changed and you want a lower EMI.
Loan Balance transfer or refinancing can help you achieve the above goals.
BENEFITS OF LOAN BALANCE TRANSFER
A lower EMI is often the most influencing factor transferring a loan balance but there can various other reasons. Let us look into them.
1. Lower interest rate
A lower interest rate means lower EMI leaving other things unchanged. A lower interest rate even by a small amount can mean a substantial amount of savings for a comparatively long loan term.
2. Longer or Shorter loan tenure
A borrower may find the EMI unaffordable and want to lower it. A longer tenure reduces the EMI although increases the total interest payable in the life of the loan. The new lender may allow the borrower to extend the loan tenure.
The opposite can also happen where the borrower wants to pay back the loan quickly by paying higher EMI but the current lender refuses to allow that.
3. Top-up Facility
Many lender offer top-up (more credit) at competitive and relatively lower rates at the time of loan balance transfer. Also, the documentation required for the top-up amount can be minimal compared to a fresh loan.
4. Better Features
Many lenders may sweeten the deal with lower (or zero) processing fee, waiver of some EMI etc.
5. Better Customer Service
One of the reasons for loan balance transfer may be simply dissatisfaction with the customer service provided by the current lender.
COST ASSOCIATED WITH LOAN BALANCE TRANSFER
While there can be various benefits of a loan balance transfer, a borrower should not ignore the costs associated with the balance transfer. There can be various costs such as stamp duties, processing fee, documentation charges etc.
Ask both your current and potential lender about the costs of such transfer before making a decision.
The process starts with taking consent from the existing lender with documents required to make the refinancing application.
With the documents provided by the current lender and other documents required by the new lender (such as identity proof, address proof, income proof etc. ) you need to apply to the new lender.
If the application is accepted, the new lender will transfer the outstanding loan amount to the old lender and the old lender will close the loan account.
The old lender will also hand over any loan-related documents such as pledge, property documents, financial securities etc. if the loan was secured by assets.
The new lender will process the loan application and you can start paying EMI to the new lender.
Consider a situation where person X use person Y’s name to purchase some asset such as real estate, shares, debentures, fixed deposits etc. to hide the fact that the money used for this transaction is earned through illegal means. This is is fundamentally what the Benami Property Transaction is all about.
SO, WHAT IS A BENAMI PROPERTY TRANSACTION?
The name “Benami” to use for such transactions is a little misleading. “Benami” means without a name whereas these transactions are best described as proxy transactions where the person entering into the transaction is neither paying the funds to procure the asset nor the beneficial owner of the property.
The person whose name is used as a proxy in the contract is called the “Benamidar”. A Benamidar does not have any beneficial interest in the asset.
The Benami Transactions (Prohibition) Act, 1988 was enacted to prohibit benami transactions.
The Benami Transactions (Prohibition) Amendment Act, 2016 empowers certain authorities to attach and confiscate assets transacted through Benami transactions and also lays down the penalty and punishments for such transactions.
WHICH TRANSACTIONS ARE BENAMI?
According to section 2(9) of the Benami Transactions (Prohibition) Act, 1988, the following criteria are set to identify Benami Transactions.
a. Property is transferred to or is held by a person and the consideration for such property has been provided or paid by another person.
b. The property is held for the immediate or future benefit, direct or indirect for the person who has provided the consideration.
c. The following are exceptions
i. A Karta or a member of a Hindu Undivided Family (HUF) is the beneficial owner of an asset whereas the consideration is paid by known sources of the HUF.
ii. A person who has fiduciary responsibility for the benefit of another person. Example - a trustee, executor, partner, director of a company, a depository or a participant as an agent of a depository etc.
iii. An individual's transacting in the name of her or his spouse or child.
iv. An individual acting in the name of brother or sister or lineal ascendant or descendant, where the names of brother or sister or lineal ascendant or descendant and the individual appear as joint-owners in any document and the consideration for such property has been provided or paid out of the known
sources of the individual.
d. If a transaction is carried out in a fictitious name.
e. When a transaction or arrangement carried out in the name of a person who is unaware of such transaction/ arrangement or denies such transaction/ arrangement.
f. A transaction or an arrangement where the person providing the consideration is not traceable or is fictitious.
PENALTY AND PUNISHMENTS
A person entering into a Benami transaction can get 1-7 years of prison time and a fine up to 25% fair market value of the asset as per section 53 of the Benami Transactions (Prohibition) Act, 1988.
If a property is proved to be held Benami, the person on whose name the asset is held or any other person claiming to be the real owner cannot have an enforceable claim on such property.
The Benamidar will not be allowed to re-transfer the asset to the real owner or any other person acting on behalf of the real owner. Any such re-transfer will be null and void.
So many times people who are good with money are labelled as “cheap”. It is true that cheap people exist who do not part with their money no matter how much benefit a particular transaction will bring. Frugal people, on the other hand, base the decision on spending on the utility.
Being cheap involves an emotional reaction to money whereas being frugal involves planning and rationality.
EMOTIONAL AND RATIONAL REACTION TO MONEY
Be honest. What is your reaction to a “SALE” or “X% off” sign on things you do not have any plan to buy?
Do you end up buying the things on sale even if you do not need it?
Take another situation. You are at a shop buying something which you are going to use regularly. You have two options. The second option is 50% pricier than the first option but from past experience, you know that it will last twice as long as the first option. Apart from that, it also looks more presentable.
Do you feel pain paying the 50% premium?
Do you feel that it is better to buy the cheaper one “for the time being”?
The above situations show how we react emotionally to expenses. Unfortunately, people who end up buying things they do not need on “SALE” also buy the cheaper option.
Let us take another situation. You just got your first salary or a handsome bonus. While coming back you see an expensive gadget or a piece of jewellery which you are not sure you will use. But, we often end up buying such expensive things which we will never use.
So, what is the rational approach?
The first requirement is knowing what you need and what you are going to use. I am not saying that you start thinking about whether you need something or not when you see the “Sale” sign. I am saying that you have a clear idea about the things you need and use and only buy things you are going to use. The “sale” is a price opportunity and it should not influence what you buy or how many you buy but at what price you buy it.
So, a frugal person knows what to buy based on the expected utility of such items. She pays a premium when she expects to receive higher utility and avoids paying a premium when no utility is expected from such a premium.
Being frugal is not about buying low-quality items or not having any aspirations. It is about evaluating the utility and paying the price for the utility. It is about planning.
One vital requirement to become frugal is understanding utility.
The most important nature of utility is that it is totally personal. You only can decide what is of higher and lower utility to you. The utility of Rs. 100 at the hands of a homeless is much more than in the hands of people reading this.
Another important nature of utility is that it is multi-faceted. We often get confined to direct economic benefit or economic utility ignoring the other factors which may have a greater impact on our wealth in the long term. So, what are the different kinds of utilities?
1. Economic Utility
This is straight-forward money made or saved. For example, buying a house will save rent expenses.
2. Convenience Utility
Utility from saved time and /or saved physical exertion. For example, owning a vehicle may not only save waiting time but also save the physical discomfort of public transport.
3. Social Utility
Utility from increased social capital. Consider that you joined a new organisation and you noticed that people here wear a specific brand of clothes which is a little expensive.
Investing in the more expensive clothing will help you fit in and grow in the organisation.
4. Health Utility
Utility from being healthy. In India going to the gym is often considered as a luxury. But, given the long term savings from health care costs and loss of productivity that regular exercise can save us from, it is a prudent investment. Same goes with choosing nutritious food options.
5. Emotional and Safety Utility
Certain things make us emotionally secure. Ignoring the emotional aspect may lead to loss of productivity. Also, feeling safe helps us to be more productive.
SO, HOW TO BE FRUGAL?
The first step is deciding and planning on your lifestyle. Decide what kind of accommodation, clothing, utilities maximize the utilities in your case mentioned above.
One example is deciding on the style of clothing you are most comfortable (based on appearance, quality, price etc. ) with. Then decide how many such apparels you actually use and how many you should own at any point in time. Make a list of such item you should have in your wardrobe.
Now, build your wardrobe slowly. Take advantage of “sale” and “discount” when you can.
The key is not to be impulsive nor scared of spending money but to have a plan.
In the last post, we talked about the commission structure for mutual funds distributors.
In this post, we will talk about the commissions for life insurance distributors. It is important for the insurance buyers to understand the incentives insurance distributors receive because the policies suggested by them may get influenced by those incentives.
Insurance buyers are advised to inquire about the specific commission structure for the distributor and the insurance product they are dealing with because it can vary significantly for different insurance companies.
Also, note that as per section 41 of the Insurance Act 1938, insurance distributors are not allowed to provide any rebate on the premium from their commission.
Insurance distributors receive a commission as a percentage of the premiums their clients pay.
From a premium payment point of view, there are two types of insurance products -
1. Single Premium Products where the premium is paid once as a lumpsum.
2. Regular Premium Products where the premium is paid at regular interval say monthly, quarterly etc.
Note: Different types of life insurance policies:
At the outset, a higher premium means higher earning for the distributors. Insurance distributors have a natural incentive to sell insurance plans with a higher face value which calls for higher premiums even if the client may not need it.
Use the following link to understand how life insurance needs to be calculated:
But, the commission of the distributor varies by the type of insurance product.
IRDA has mandated the current commission structure for the insurance distributors through IRDA (Payment of Commission or Remuneration or Reward to Insurance Agents and Insurance Intermediaries) Regulations, 2016 which is into force from 1st April 2017.
Refer to the attached image for the limits on commission set out by IRDA.
Mutual Fund distributors act as the bridge between the asset management companies and investors. For most first time investors, taking advice from a distributor adds value in knowing about the available options and choosing the suitable option. But, like any other profession, the way distributors and incentivised can have a profound impact on the quality of advice provided by them.
Let us understand the commission structure of Mutual Funds and how it can influence the advice provided by a distributor.
TYPES OF COMMISSIONS
There are primarily two types of commission.
1. Upfront Commission
This is the one-time payment to a distributor my an asset management company when a distributor sells a mutual fund scheme to a client.
2. Trail Commission
Trail commission is a recurring commission paid by an asset management company to a distributor based on the mutual fund schemes sold through the distributor. So, your distributor will receive the trail commission till your redeem your mutual fund units.
AMCs calculate trail commission for a distributor on the daily net asset under management of the distributor.
Note: The actual percentage of commission paid to the distributor depends on the AMC, the type of mutual fund scheme and location because AMCs often pay a higher commission to distributors in cities with low mutual fund penetration.
WHAT IS UPFRONTING OF THE TRAIL COMMISSION?
Sometimes the asset management may pay the trail commissions in advance as a lump-sum to the distributors instead of recurring payments. This is called upfronting of trail commission.
IMPLICATIONS OF TYPE OF COMMISSIONS
An upfront commission incentivises the distributors to increase the number of transactions as the distributor receives the upfront commission on new transactions. This means that distributors may often encourage investors to churn their mutual fund portfolio even if it is not required. This increases the transaction costs for the investors and lowers the return for the investor.
The trail commission is tied to the NAV of the units already bought through the distributor and the distributors receive trail commission till the units are redeemed. The trail commission incentivises the distributor to increase the asset under management, choose mutual funds which are expected to perform better and encourage investors to keep invested for longer.
The role of regulation is to encourage a commission structure which aligns the incentives of the distributors with that of the investors. Keeping that in mind, SEBI has in October 2018 mandated a full trail commission, banned upfront commissions and upfronting of trail commission except in the case of SIPs.
Upfronting of trail commission for SIPs is allowed in case of first-time mutual fund investors up to 1% for maximum 3 years. This will require the R&T agents to identify the first time investors using PAN numbers.
In the meantime, upfronting for SIPs will be allowed on SIP inflows of maximum Rs. 5000 per month, per investor across all schemes of a mutual fund. This upfronting shall be up to 1% of total SIP inflows for a maximum of 3 years.
Additional TER of 30 basis points (0.3%) for the individual investors located beyond the top 30 (B 30) cities. The additional commission for the addition TER can be paid in trail only.
Many novice investors often choose stocks simply because they pay a higher dividend. Where some part of it is Loss Aversion at play (“If I get money back as soon as possible, I will not lose it”), the primary reason is a lack of understanding about the mechanism through which companies decide the dividend payout.
In this post, we will discuss how companies make the dividend decision and what it means for an investor.
CHOICE OF DISTRIBUTION AND REINVESTMENT
Consider you started a small business 5 years ago. You did not have enough capital so your four friends helped you in that. Each of you owns 20% of the business.
At the end of the recent financial year, the business made a net profit of Rs. 10 lakh after paying all bills and a decent salary to you for managing the business.
What would you do with that money?
Will you distribute the money equally with all your friends i.e. Rs. 2 lakhs each?
Or will you reinvest that money in the business?
Companies face this choice every year. It does not have to be all or nothing. Most companies distribute part of their net income as dividends and the ratio of the amount distributed to the net income is called the Dividend Payout Ratio.
For example, if you decide to distribute Rs. 5 lakhs and reinvest the other half then the Dividend Payout Ratio is 50%.
WHAT INFLUENCES THE DECISION?
How would you decide how much money to reinvest and how much to distribute? For a company, it is about the best utilisation. Consider that you think that you need to invest at least Rs. 2 lakhs to maintain the sales and Rs. 5 lakhs of further investment can increase the profits of the business by 20%. Now, if you decide to reinvest the Rs. 7 lakhs from the business, you can distribute the rest Rs. 3 lakhs i.e. a Payout Ration of 30%.
The choice of Dividend Payout Ratio depends on the available investment opportunities for the business. Availability of the investment opportunities depends on many factors including the growth prospects of the market, the growth prospects of the company, expected macroeconomic conditions etc.
In short, a higher Dividend Ratio means that the company does not have enough investment opportunities for future growth. This generally happens for matured companies in saturated markets.
WHAT DOES IT MEAN FOR AN INVESTOR?
For an investor who is looking for growth in their portfolio, high dividend paying stocks may not be the right choice. In the long run, the sustainable growth rate of a company gets influenced by the Dividend Payout Ratio as follows
Sustainable Growth Rate = ROE X (1- Dividend Payout Ratio)
ROE = Return on Equity
ROE shows the ability of the company to convert equity investments into net income. ROE is a combined effect of the ability to generate revenue, profitability and financial leverage.
As mentioned before, a higher Dividend Payout Ratio often means a lower growth prospect for the company and in turn the share price of the company.
Life changes after retirement. You get the freedom and time to do things you always wanted but could not find time for. On the other hand, your source of income takes a drastic change. Depending on whether you have a pension plan or not, your regular income either decreases quite a bit or completely disappears.
But, you may also receive a large chunk of money from the providend fund, gratuity etc. Given this situation, we need to change our personal financial management. In this post, we will look into different aspects of it.
FINANCIAL PRIORITIES AFTER RETIREMENT
First, let us understand how financial priorities change with retirement.
1. Risk Tolerance
There are multiple factors that affect our risk tolerance after retirement.
Lack or reduction of regular income decreases our risk tolerance quite a bit. High-risk investments tend to be illiquid.
The investment horizon also keeps on reducing as we age. This increases the need for preservation of capital.
2. Investment Objectives
As our regular income takes a hit after retirement, our savings need to recoup for the lifestyle expenses. This means investment objective changes from growth to the preservation of capital and liquidity.
3. Changing expenses
The type of expenses changes as we age. One obvious change is medical expenses which tend to increase with age. People often receive medical benefits from employers. These benefits may not be available after retirement.
Also, you may want to travel or indulge in other hobbies after retirement requiring higher liquidity.
SO, WHAT SHOULD YOU DO?
1. Evaluate financial changes
The first step is to take the time to evaluate the changes in your financial situation which you are going to face with retirement.
How is your monthly income going to be impacted?
Will you lose your medical benefits?
Will you lose the company provided residence?
Will you need to relocate?
2. Create a plan to manage the changes
Now, you need a plan to deal with the changes.
For example, you may find that there will be a significant shortfall of monthly cash-flow after retirement. You may deal with this by buying annuity plans.
You may find that you are going to lose your medical benefits. You may plan to buy private medical insurance for you and your spouse.
If you have to relocate, you may plan to buy a new residence with the retirement benefits.
3. Respect higher liquidity needs
Planning your finances after retirement can be daunting and it is easy to drastically underestimate your liquidity needs. We are often unaware of the employment benefits we receive before we lose them.
While planning for your monthly cash requirements add an abundant margin of safety. Avoid any situation where you do not have enough cash to pay the bills. Create a large enough emergency fund which you can withdraw from any time you want.
2. Take a phased approach in portfolio re-allocation
Retirement calls for re-allocation of your portfolio. But, avoid changing the portfolio drastically overnight. The re-allocation should ideally start before retirement and continue much after retirement.
While liquidity requirement changes drastically, the time horizon decreases gradually. So, your risk tolerance after retirement does not decrease drastically. Do not rush into redeeming all equity investments and invest everything in fixed deposits.
While after retirement the objective changes to preservation – you can still have a small percentage of your portfolio in equity assets much after retirement. A drastically conservative portfolio just after the retirement may lead to running out of savings.
3. Preparing for distribution
Another important aspect after retirement is estate planning i.e. creating a plan for the distribution of assets to your next of kin.