Risk planning before borrowing a home loan:

Borrowing a home loan is one of the important financial decisions in an individual’s life. Managing financial resources after taking a home loan could be as taxing as hunting for a value-for-money property. The obvious risks involved in taking up a home loan liability include sale of house by bank in the event of the borrower’s death or loan default, rise in interest rates, decrease in repayment capacity due to loss of job or other unforeseen factors. Proper risk planning will enable a home loan borrower to take care of the EMI payments and also to manage other financial goals. This includes: 

1. Reserve emergency funds:  Payment for a property purchase includes some amount of home loan and the balance as down payment from a borrower’s own funds. Making a down payment for a house is one of the events which usually entail a big cash outflow from an individual’s savings. The borrower should make sure he does not hit rock-bottom in his savings post the property transaction. Contingency funds (preferably six month expenses) will help a borrower tide over unexpected circumstances like a medical emergency or loss of job. 

2.Assess EMI affordability:  Before taking a loan, a borrower should assess how much monthly instalment he can afford to pay from his net take-home salary apart from meeting his household & personal expenses. Additional expenses in the new home in the immediate term like interior decoration, painting and furniture need to be discounted. Further, maintenance expenses in a new building will be higher compared to an old building. There are instances where many families decide to stay separate from their dependant parents after buying a new flat and maintain two homes. In such cases, household expenses are likely to be on the higher side. All these factors need to be discounted while assessing the EMI capacity.

3.  Study EMI structure: A borrower should know the EMI break-up as it will help him take prepayment decisions and also decide upon the tenure of the loan.  The EMI payment of a loan has a principal and interest portion.  

   Many people are not aware that in the initial years of repaying loan, interest component is very high compared to principal repayment.  For instance, suppose Mr.A borrows a home loan of Rs.45 lakhs for tenure of 20 years at an interest rate of 10.75 per cent per annum from SBI. The EMI comes to Rs.45,686. In the first EMI, i.e, Rs.40313, 88 per cent of the instalment goes towards interest payment while the rest goes in principal. Effectively, the loan will be reduced by just Rs.5,373 in the first month and Rs.67,749 in the first year. Similarly, for the first five years of the loan, the total interest charges come to a whopping Rs.23,16,741, which is 51 per cent of the loan amount.  This is assuming Mr.A did not repay any amount during this period. The principal amount at the end of five years would have reduced by just Rs.4,24,419, which is 9.4 per cent of the original loan amount.

   It thus becomes crucial to prepay small chunks every month or quarter in the initial years which will reduce the outstanding amount. Now that the RBI has removed the prepayment penalty charges, a borrower can repay as much as he wants at any time of the year.

 4. Deciding on the tenure of the loan:  The monthly instalment for a loan with a longer tenure will be smaller than the one with a shorter tenure. Many a times, borrowers opt for longer tenure loans thinking that they will repay the loan in 5-6 years and pay less EMI. However, it is important to note that a borrower pays more interest on a loan with a longer tenure or a bigger principal. For instance, Mr.B borrows a loan of Rs.45,00,000 from SBI at 10.75 per cent per annum and prepays the loan at the end of 8 years itself. If he opts for a 20 year loan, he will end up  paying Rs.35,73,686  as interest  over the 8 years whereas the  interest will be Rs. 33,11,290 for a 15 year loan. Effectively, he ends up paying Rs.2,62000 higher interest if he goes for a longer tenure  loan.
 
5. Compare home loan packages across banks: It is prudent to pick 3-4 banks of choice and enquire about home loan packages. A borrower can prepare a questionnaire before making home loan enquiries with bank staff regarding eligibility for home loan, interest rates, tenure of the loan, period for approval & sanction of home loan, reasons for home loan rejections, mortgage & property insurance and incentives available (e.g,waiver of EMI, moratorium period in case of loss of job). While considering different loan packages of banks, a borrower should compare their repayment schedules and the total interest payable over the tenure of the loan. While the EMI calculation will be the same as per formula, the interest portion charged by different banks in the initial years of the loan may vary. A borrower should also enquire about teaser packages where promotional rates or fixed rates are offered in the initial years.
 
 6. Buy insurance to cover home loan risk: A house is in the borrower’s name only after he repays the full loan amount.  In the event of the borrower’s death during the interim loan period, his family can face eviction from the house if they could not afford to pay EMIs. Buying life insurance will help a family pay off the outstanding loan amount in the event of borrower’s death. Term loan insurance is a cheaper and better option compared to home loan protection packages offered by banks. A pure term insurance cover will remain constant for the entire tenure of the loan and will offer a fixed benefit in an unfortunate event. Home loan insurance on the other hand will offer reduced benefit which is in proportion to the outstanding loan amount. Also, an insurance contract bought from a bank may turn void in case a borrower switches to another bank. A new cover will be required to purchase from another lender.
 
7. Pay off your home loan as soon as possible: There have been many debates about whether it is beneficial to continue home loan or prepay them at regular intervals.  The usual argument here is if a borrower gets returns which are better than the interest rate of the home loan, he should invest his savings rather than utilise them in prepayment of loan. Considering the volatility in interest rates, a borrower needs to take into picture the whole tenure of the loan rather than few years where floating interest rates have been lower than investment returns. For instance, in 2009, interest rates were in the range of 8-9 per cent and equity markets were yielding returns of at least 25-30 per cent. Presently, interest rates are hovering around 10-11 per cent and equity markets are yielding poor returns or in the negative.  By the time, a borrower decides to prepay his loan because of the increased burden, the bank would have recovered a major portion of his interest. Keeping a periodic target and clearing off the loan is thus prudent.  Prepaying the loan and receiving legal possession of the house will offer peace of mind to borrower compared to the loan liability hanging over his head.    

Five personal finance resolutions in 2012:

Many new resolutions must have been broken or forgotten already by the end of just second week of 2012. But we all like to start afresh guided by a persistent willingness every time, don’t we? The plan of starting anew provides motivation for any individual to bring about a change in any aspect of life which he/she is not satisfied with. More so, in financial matters because financial worry (severe or mild) is something which plagues every individual. So let us resolve to put our finances in order from 2012.

1.  Review your finances regularly & keep a record: First and foremost, inspect your finances. This exercise includes reviewing your investments, insurance, liabilities and monthly cash flows. This will help generate a view on your financial position and determine your net worth (Financial Assets – Liabilities). You can classify your resultant net worth figure into long term and medium-short term savings. Long term savings will include investments in PPF, NSC, EPF, long term bonds, pension scheme, etc. Medium to short term savings include bank savings, fixed deposits, stocks, equity and debt mutual funds. You can make a habit to review your net worth on a monthly/quarterly basis in an excel sheet and track whether it has grown or declined.
2. Organise your financial documents: Misplacing financial records including insurance policy documents is a common mistake. It could add to unnecessary stress if not found at the crucial hour. Make sure you keep all your financial records at one place. Get into a habit of filing records. You can categorise them into banking, investments and insurance. Intimate your family members about the placement of the financial documents so that they do not have any trouble finding them in your absence.
3. Journal your expense and stick to a budget: You might have some idea about the extra money going out of your pocket during these inflationary times. If you keep a record of every dime spent you will be able to curtail unnecessary spending over a period of time. Journaling your monthly expenses will enable you to get a better grip over your finances. (Know more about budget management in my article dated 8 June, 2011 titled ‘Where is your money going?’)
4. Create an emergency fund: Set aside some funds in the event of emergencies like a medical situation, loss of job, etc. During unfortunate situations, people usually end up redeeming their mutual funds (invested to meet long term goals) or breaking fixed deposits. An emergency fund will help to tide over difficult times. These should not be touched for your day-to-day routine spending. (More on emergency funds in my post dated 16 November 2011 titled ‘Do you have an emergency fund?’)
5. Dump your expensive insurance policies: Do not jumble up your investment and insurance goals. Risk planning should include buying a cover for loss of human life. The loss of life and its financial implications should be considered for a family while buying a life insurance cover rather than investment returns. Term policies are the cheapest and purest form of insurance for this purpose. Investment planning should include saving and investing in equity and debt instruments for meeting short and long term goals of life. Avoid investing in insurance plans that have an investment element. They are expensive and offer mediocre returns compared to regular investment options.
6. Invest in equities: This is the best asset class to beat inflation over a long period of time. If you have investible surplus not required for at least five years, then you will be able to ride the volatility in the stock markets better and yield attractive returns. Investible surplus here means corpus created after meeting household expenses, EMI, insurance premium and other general expenses. The savings should also discount the amount required for any medium term goal like buying an asset or funding child education.

Taking full charge of your financial matters cannot happen overnight but small steps taken will surely bring about a visible change over a period of time. Getting a complete grip on your finances will enable you to plan your future finances better. I wish all my readers a very Happy New Year and Happy Financial Management in 2012.

Do you have an emergency fund?

To the above question, the most answers I receive are a big yes. However, I realise that most people do not understand the concept of emergency funds in a real sense of the word. Many people equate emergency funds to a common savings bank account or a salary account. Sadly, they operate the same account for cash withdrawals to meet routine expenses. The bare minimum amount keeps on fluctuating in the so called emergency fund kitty and is refurnished for a brief period when salary is credited in the first week of the month. Let us discuss the real purpose of these funds, how much is adequate and where to park them.

Significance of emergency funds: These are required in the event of unfortunate situations that life throws at us. It could be a medical crisis or a loss of job or something else. After the Global Liquidity Crisis of 2008, many employees in the IT and Finance industry were handed the pink slips. Many people take job security for granted and hence are not prepared for these kinds of situations. During a medical emergency in a family, liquid money is required even if one has bought a mediclaim policy and opted for a cashless settlement. This would be to clear ambulance charges, day-to-day medical expenses, initial diagnosis, etc. Certain hospitals even ask for a refundable deposit before settling the dues with the insurance company. During such difficult times, people usually end up breaking their bank fixed deposits or redeeming mutual funds or making huge payments by credit cards. An emergency fund helps to sail through critical times. It should thus be given precedence over your regular investments being made in equity, gold or debt instruments.

How much is sufficient: An emergency fund should cover house hold expenses of six months. This includes the groceries, utility bills, entertainment, children’s school fees, EMI,etc. It should also take into account medical emergencies as mentioned earlier. For any individual, the probability of using an emergency fund during a health crisis is higher in a lifetime than for any other situation. It could be normally about Rs.2-3 lakhs. However, it may vary from family to family. For instance, there are families where many members have chronic health problems or some have 2-3 senior citizens or some do not have adequate medical cover, sometimes none at all. Such cases warrant a higher emergency fund. The fund amount can be gradually reduced once sufficient medical cover is purchased.

Where to park emergency funds: The prime reason of maintaining an emergency fund is that an individual has access to instant cash during an unfortunate event. Liquidity and safety are the key things here rather than attractive investment returns. So, the best option to park emergency funds is a savings bank account. Another option is flexible fixed deposits with auto renewal option and linked to a bank savings account. One can break the FD during emergencies and withdraw money instantly using an ATM card. You can also split the money and put 50 per cent in a savings bank account and the rest in a flexi-FD.

Although the returns from short term liquid mutual funds will be comparatively higher, they are a riskier option. Redeeming them will take 24 hours at least (even more if it is a public holiday the next day) and the whole purpose of maintaining an emergency fund will not be served.

Before you park emergency funds, make a list of the nearest bank branches from your home and/or place of work and enquire about the ATM withdrawal limit. Distribute the emergency fund amount in at least 2-3 branches so that you can withdraw maximum amount through your ATM cards on a single days. Use the emergency fund amount for urgent crisis-like situations only. It should not be touched for your day-to-day spending affairs. More importantly, replenish you contingency fund once the emergency has passed.