Financial Discipline for all.

Principle 4. Interest rates.


INTEREST

Interest, usually expressed in terms of a percentage, is the additional amount you pay for using borrowed money or the return you get when you invest it with an institution like a bank.Its also the compensation you can demand if someone delays a payment that’s due to you. If you think clearly, the two concepts we discussed earlier viz, time value of money and compounding were based on the concept of interest rates.In this post we are discussing certain practical scenarios where interest rates can baffle you. It’s discussed under two heads

1. Interest payments

2. Interest incomes.

    INTEREST ON LOANS

    Interest rates are always tricky.  In most of the cases, interest rates advertised by the banks are not the actual rate of interest you pay. It’s something more than that.

    Trap 1.
    When you apply for a loan, there are a lot of financial charges you need to consider before deciding whether to avail it or not. For example – you are offered a loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMI’s payable in advance. Effectively, you are getting only Rs 164,000 in hand. But since the interest rate is calculated as if the entire 2 lakhs is given to you, the rate of interest you pay is actually very high.

    Is that all? No. The bank will also deduct a processing fee of 1 % of the ‘total amount’ ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000.

    Trap 2.
    You are offered the same loan for reducing balance interest. You feel light thinking of the fact that interest is charged only on the balance outstanding. But look closer – reducing balance can be on monthly basis, half yearly basis or on Annual basis. If it’s on annual basis – your interest is calculated on the amount outstanding at the ‘beginning’ of the year. So, you keep paying interest on a higher amount even though your loan is decreasing every month. This pushes up the effective rate of interest you pay.So always confirm whether the reducing balance is on annual basis or half yearly basis.

    Trap3.
    Higher loan pre-closure charges. The bank would like you to pay your EMI’s regularly. If you do that, the bank likes you so much that on the basis of that regular loan track, they will sanction a second loan if you want. But – if you try to close off your loan liability before the stipulated loan period – the bank will charge an additional amount of 3% to 4% on the outstanding principal. They don’t want their customers to be ‘Too regular’. strange isn’t it?. That’s the way bank deals with it’s customers. If you try to be too good , you’ll be fined This preclosure charge you pay effectively raises the cost of your loan.

    The solution-

    The best way to deal with these traps is to stop comparing the interest rates and instead, compare the EMI’s and compute the total amount going out of your pocket including processing fee and pre-closure charges. This will give you the right picture of which loan is actually right for you.

    INTEREST INCOME

    The principle to be applied is quite simple – The earlier you get it, the better it is.

    This principle will help you to compare different offers. For example – A bank offers 8% P.a  interest on FD , payable annually. NSC also offers 8% P.a but, payable half yearly. You get another offer on FD which pays interest at 8% p.a – payable monthly. Which is better? The one you get on monthly basis, of course!. Why? Because, the bank’s effective rate is 8% , the NSC’s effective rate is 8.16% and the third option of FD gives you an effective annual interest rate of 8.30% !

    How? Let’s calculate with an example –

    • Let’s assume that you have 2 lakhs with you.
    • The first bank would give you 8% – annually so, you receive an interest income of Rs.16,000 at the end of one year.
    • Suppose you depoited the same with NSCThey would give you  8% -half yearly. So, at the end of 6 months you get Rs 8,000 which can be again invested for 8% interest for 6 months whch gives you an additional interest of Rs. 340. So, the total interest you receive is now Rs 16,340. effective rate – 8.16%
    • Similarly , when you work out 8% interest received on a monthly basis the effective interest rate would workout to 8.30%

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    Principle 3. Compounding


    When asked to name the greatest mathematical discovery, Albert Einstein, one of the most influential and best known scientist and intellectual of all time replied – “compound interest”.

    Let’s try to understand why he said so with a very simple example:

    • Jerry starts saving when he turned 25 and invests Rs 50,000 every year. He earns a return of 10% every year.At the end of ten years; he has been able to accumulate Rs 8.77 lakh. After that, he dosen’t invest Rs 50,000 anymore. He leaves that investment there until he’s retires at 60. At that time,  he would have accumulated around Rs 95 lakhs .
    • Tom, had fun and lived his first few years spending on all kinds of things and did not think of investing regularly. At 35, he starts to invest Rs 50,000 regularly every year until he retires at 60. I.e. for 25 years. But, he would have managed to accumulate only Rs 54.1 lakhs which is around Rs 41 lakhs less in comparison to Jerry.

    5 simple points spell out from this story:

    • Even by investing two-and-a-half times more than Jerry,Tom has managed to build a corpus which is 43% less!
    • Why? Because,Jerry’s Rs 5 lakhs was allowed to compound for a longer period of time than Tom’s.
    • As the fund grows, the impact of compounding is greater.Jerry starts at 25, accumulates 50,000 for ten years, stops at 35 and then, his 8.77 lakhs (5 lakhs + Interest) is allowed to compound for 25 years till he’s 60. Whereas Tom starts at 35 and invests Rs 50,000 for the next 25 years, accumulates 12.5 lakhs (50,000 x 25) only to get 54.1 lakhs at 60.
    • Now let’s assume that Jerry had allowed the fund to compound for only 20 years i.e.  Till he turned 55. At 10% return every year, he would have accumulated an amount of around Rs 59 lakhs. By choosing to let his investment run for 5 more years, he accumulates Rs 45 lakh more.
    • Essentially, compounding is the idea that you can make money on the money you’ve already earned.

    Compounding is very powerful.As Napoleon hill has said- “make your money work hard for you, and you will not have to work so hard for it” To take advantage of it, you have to start investing as early as possible.The earlier you start, the better it gets.

    Easily said ! isn’t it?

    I know it generally doesn’t work as i said. Because at 25, most of you haven’t drawn a plan to invest 50,000 a year. Even if you’ve done it , somewhere down the way , you’ve missed to add to your corpus regularly year after year. And , due to some emergency that crept in, you took back some amount from the corpus and din’t let your money grow !

    So , how can a regular person use it to his/her advantage? Always remember to reinvest interest or dividends received on your investments. Over a period of time, such small amounts will add up to a tidy sum.

    FREQUENCY FACTOR IN COMPOUNDING

    The frequency of compounding is a major factor that that influences the compounding effect. The shorter the compounding frequency, the earlier your interest is re-invested and thus you earn more interest and your money grows faster.

    Here’s more examples:

    • Savings of Rs 2500/- per month (Rs.30000 Per year) with 15% return will be worth Rs. 15028707/- (1.5 Crores) after 30 years. Yes, this is not typing error. It will be worth Really 1.5 Crores.
    • Savings of Rs 2500/- per month (Rs.30000 per Year) with 15% return will be worth Rs. 30400370/- (3.04 Crore) after 35 years.

    COMPARATIVE CHART.

    Here is a comparative chart for you to understand.

    Let’s assume that you invest Rs 10,000 annually. Your retirement age is 60. Let’s also assume that the interest rate you get is 10%.

    At the age of 60 you will have -

    • 49 lakhs -if you had started investing from age 20.
    • 30 lakhs -if you had started investing from age 25.
    • 18 lakhs – if you had started investing from age 30.
    • 11 lakhs – if you had started investing from age 35.
    • Just 6 lakhs – If you start at 40!! Take note of the impact.

    Oh! That’s a huge difference! Now that you realized it late, what can you do? You can start now, invest more and reach the target of 49 lakh at age 60. This would mean more hard work and budgeting for you.   Let us see how much more you would need.

    To get 49 lakhs at age 60 –

    • Invest 10,000 annually – at age 20
    • Invest 16,500 annually – at age 25
    • Invest 27000 annually – at age 30
    • Invest 45,000 annually- at age 35
    • Invest 78,000 annually – at age 40!!

    Generally what I find is that most of the Indians start thinking of saving and investing at the age of 30-35. The above calculation is made assuming that the interest rate you get is 10 percent. But the average interest rate of banks is less than that. I hope the picture is now clear for you. The more you delay, the more you need to invest.

    Hope you have understood the concept of compounding and how it impacts your savings. That’s principle 3 for you.

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    Principle 2.Time value of money



    The best money advice anyone can ever give you is the “time value of money” concept . It is a vital concept in finance. Every financial decision involves the application of this concept directly or indirectly.The calculation of time value involves simple mathematics and it’s easy to calculate. Since this topic is a very important to everyone, we put it down as principle number two.

    ENTER-TIME VALUE OF MONEY

    The principle is – Rs 100 today is more valuable than Rs 100 a year from now. The reasons for this is quite simple to understand -

    • First, since the cost of living goes up , your money will  buy less goods and services in the future .So, today, money has more value or the purchasing power of your money is more
    • Second, if you have that money today, you can invest and earn returns.When you receive the money at a future date instead of receiving it today, you lose the interest or profit you would have made, had this money been with you now
    • Third, you prefer to have money today since the future is uncertain.

    EXAMPLE :

    Lets’s assume that you are  25 years old. You have Rs.2500 with you now. You  can either put it in bank FD or buy yourself a new dress. Now, let me further assume that you opt for buying new dress.The reality is that you are spending far more than that Rs 2500. How? Let’s try to calculate the real cost of not investing that money.

    FV = pmt (1+i)n

    FV = Future Value
    Pmt = Payment
    I = Rate of return you expect to earn
    N = Number of years


    HOW TO SOLVE THE EQUATION?

    N = Number of years invested - The money you’ve spend on a dress is lost forever. That means,  that  Rs 2500 could have compounded in the bank for atleast 35 years.  How did i get that ’35′ figure? I assumed that you’ll retire at 60 and since you are 25 now, there’s 35  years left. let’s substitute 35 for “n” in the equation.

    I= Rate of return expected – The ‘I’ in the formula stands for the expected rate of return. Since  bank fixed deposits would pay around 8% and   stock markets have returned an average of 15 %- 17% ,  Let’s assume you would earn some where in between – an average of 10% rate of return. So, we’ll assume  ’I’ as 10% .

    PMT –  is the value of the single amount you want to invest (in this case Rs 2500).

    Now substituting the figures, our   formula would be –  FV = 2500 (1+.10)35.

    Enter 1.10 into your calculator (this is the sum of 1+.10). Raise this to the 35th power. The result is 28.1024. Multiply the 28.1024 by the pmt of Rs 2500. The result (Rs 70,256 ) is the true cost of spending the Rs 2500 today (if you adjusted the Rs 70256  for inflation of 6 % , it would probably work out to about Rs 9150  That means your real purchasing power would increase approximately 4 fold).

    Now,  after realizing the actual cost of spending Rs 2500,   would you prefer to buy a dress for Rs 2500 today or Rs 9150 in the future. The answer is entirely personal.

    Once you understand this vital concept,  you would realize that all those bits and pieces of money you spend unnecessarily are costing you thousands in future wealth. This is why time value of money is considered as the central concept in finance.

    MORE EXAMPLES..

    Future value of money –compounded annually.
    You deposit Rs 50,000 for 5 years at 5% interest rate compounded annually. What is the future vale?

    • FV= PV ( 1 + i ) N
    • FV= Rs. 50,000  ( 1+ .05 ) 5
    • FV= Rs. 50,000  (1.2762815)
    • FV= Rs. 63,815.

    Future Value of money – Compounded Monthly
    You deposit Rs 50,000 for 5 years at 5% interest rate compounded monthly. What is the future value?

    (i equals .05 divided by 12, because there are 12 months per year. So 0.05/12=.004166, so i=.004166)

    • FV= PV ( 1 + i ) N
    • FV= Rs. 50,000 ( 1+ .004166 ) 60
    • FV= Rs. 50,000 (1.283307)
    • FV= Rs. 64,165.

    GOING BACKWARDS.

    Present Value of money – Compounded Annually
    You will receive Rs 50,000 5 years from now.  How much money should you get now instead of Rs 50,000 5 years later if the interest rate is 6%?

    • (i=.06)
    • Rs.50,000 = PV ( 1 + .06) 5
    • Rs.50,000 = PV (1.338)
    • Rs.50,000 / 1.338 = PV
    • Rs. 37,370.

    Present Value of money – Compounded Monthly

    You will receive Rs 50,000 5 years from now.  How much money should you get now instead of Rs 50,000 5 years later if the interest rate is 6% calculated on monthly compounding basis?

    • Here , (i equals .06 divided by 12, because there are 12 months per year so 0.06/12=.005 so i=.005)
    • FV= PV ( 1 + i ) N
    • Rs.50,000 = PV ( 1 + .005) 60
    • Rs.50,000 = PV (1.348)
    • Rs.50,000 / 1.348= PV
    • Rs. 37,091.

    KNOW IT

    • A rupee received today is greater than a rupee received tomorrow because money has ‘time value’
    • The time value of money is the compensation for postponement of consumption of money. It is the aggregate of inflation rate, the real rate of return on risk free investment and the risk premium.
    • ‘Time value of money’ can be different for different people because each has a different desired compensation for postponing the consumption of money.

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    Principle 1.Finding money !

    That’s interesting! This is one topic everyone will read very carefully because it all about finding money! Imagine that you found Rs 1000 between the pages of an old book on the shelf. You kept it some months back and forgot about it. How does it feel? Even if that money was never found, you would have still lived with what’s left in your wallet without even bothering where it disappeared. isn’t it?

    This is the principle behind accumulating savings from your income. Set aside your target savings and forget about it as if it were not there and live with the rest. It’s not easy as you think,but definitely not impossible. And , it’s never too late to apply this principle !

    To most of us Savings = Income (or salary)- Expenses . However, this formula doesn’t work ( as you would have already experienced :) ) since when money is in your pocket, you get trapped by advertising tricks like discount offers on Clothes or new gadgets which tempts you to spend more. It’s difficult to control expenses. As a result, your savings never hits the target. If what we said holds true for you and you seriously want to save a fixed 10% or 20% of your take home salary each month, you need a different approach to savings. We suggest Robert Kiyosaki’s method from his famous book ‘Rich Dad Poor Dad’.

    What kiyosaki said is very simple. Instead of trying to limit your expenses every month, first deduct an amount which you intend to save and keep it in a separate account so that you live with only what’s left. So our formula has to be modified like this :

    INCOME – SAVINGS(INVESTING FUND) = EXPENSES

    Smart ! isnt’ it ? This formula forces you to “pay yourself first,” before the other expenses. That way you know your savings will not get lost in the daily grind of living expenses.

    The other side of this formula is a forced discipline. You hold your expenses to no more than 90% of your take home pay.

    You can even automate the process by having 10% (or any amount you want) deducted from your Salary account and transfer it into a separate account or fixed deposit, recurring deposit or other savings instrument .

    So that’s the basic trick to find money!

    But, that’s not all. You can also find money from many other sources. For example, Instead of going for parties and shopping, you can set aside extra payments like bonuses, commissions and so forth into your savings Fund.

    So try to make it a habit to set aside 10% ( or what ever percentage you would like to set aside) and live with rest. If you do that, you have a great chance to succeed.

    MORE TIPS TO CONTROL YOUR EXPENSES:

      SPEND LESS

      This is one simple method to save more. Sit back and analyse your spending habits and look where you spend more unnecessarily. Once you have identified certain areas of high spending, try to find ways to cut back. Take a decision that you’ll not spend more than a fixed budget.

      MAKE A BUDGET

      A budget is a very important tool to control expenses. Be it individuals or corporates. A budget is nothing but a chart or a statement that shows how much you earn and hence, how much you can spend.

      PAY OFF YOUR LOANS

      Loans carry high rates of interest. If you have a lot of EMI’s to pay, it naturally reduces your capacity to save more. It also shows that you’re living on high levels of debt which is not a right thing to do. If you have loans, first look for ways to pre-pay it as soon as possible. Another common area where you could lose a lot of money is credit cards. Credit cards companies slap huge interest for delayed payments.

      TRY TO AVOID LATE PAYMENTS

      Any bills – like electricity or telephone or internet or credit card has a deadline within which you are supposed to pay the dues. Unnecessarily delaying such payments results in payment of fines. Such expenditures can be avoided if you can get organized on your bill payments. Make a list of monthly payments and the deadline within which you are supposed to pay. These days banks also allow their customers to automate or link their periodic bills to their savings account or credit card.

      Credit cards over dues need particular mention here. Credit card companies slap huge interest and fines for delayed payments.

      THINK BEFORE YOU BUY

      Do not buy anything on impulse. Before laying your hands on any fancy thing which is up for sale, think if it’s really needed.

      SHOP SMART

      Most of the big brands will be available at throw away prices once there’s an off season sale or sales promotion drive. For example if you want to buy an expensive watch, wait for the company to announce some discount offers. All the big brands announce discount offers at least twice a year.

      KEEP DISTANCE FROM LAVISH FRIENDS

      High spending lavish friends are may hinder your route to save money. It’s natural for you to get tempted by such friends to buy new gadgets every year. They may be nice guys and may not harm you in anyway, but to keep up with them , it may become necessary for you to spend high ( for example latest electronic items or cars , parties, expensive dresss etc ) which other wise ay not be required !

      SAVING ENOUGH IS HALF THE JOB DONE

      If you have saved enough,good. but saving is only half the job done.You have to give your savings the right opportunity to grow. Putting all your funds in fixed deposits or fixed income bonds is not a good idea. Your investments should have the right mix of equities, bonds, gold and fixed deposits.Deciding the ‘right mix’ of investments is something an investment expert can do. It depends on an individual’s age and risk profile.


      KNOW IT

      • Finding money is a matter of making it a priority.
      • Pay yourself first and learn to live off with what is left. You will always have money with you. It may be difficult at first. But gradually, you will see your fund growing and that would encourage you to stick to it until you reach your goal of finding enough money.
      • Bonuses and extra pays you get are opportunities to buy the latest iphone or Blackberry but a prudent option would be to create a savings out of it
      • You can save a lot of money if you control your expenses.
      • As time goes by, your small saving will also give you additional money in the form of interest. Finally, you’ll find that you’ve done a great job,creating more money than expected.

      Take our word. It’s fool proof !!

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