The High Cost of Financial Mistakes:

“I have decided to discontinue my life insurance policy”, said my good friend.  He bought an endowment plan from a life insurance company five years ago for a sum of Rs.8 lakh and was paying an annual premium of about Rs.43,700.

I was surprised why he would want to discontinue life insurance cover in his young working age. I wondered he might have suddenly inherited some native land worth crores which would take care of his dependants throughout their lifetime in his absence.

I asked the reason and he replied in desperation, “I simply cannot afford it now as the insurance premium is very expensive and my loan EMI has started on the new house bought recently”!

I did not appreciate the reason which guided him to take a decision of discontinuing the life insurance policy. The reason was of affordability and not because my friend did not require life insurance anymore. Nonetheless, I guided him to first buy a pure term insurance cover – the cheapest form of insurance, increase his sum assured which would also cover the home loan and then discontinue the endowment policy.

I have observed umpteen such cases where people have second thoughts about a financial product but after buying it. They are then stuck up with products which they do not really require or are not beneficial to the core.

Are you also one of those who buy a financial product first and regret later? We all make financial blunders at one point or the other in our lives. Some of us realize it early on and try to rectify them. Some of us drag along with the mistakes not realizing the consequences it may have on the financial situation for the rest of our lives.

The impact that these financial decisions have on an average salaried individual is huge compared to a high net worth individual. I have observed many instances of high net worth individuals (HNIs) where life insurance has been bought even if not required. A case of excess insurance! The super rich have built so much of wealth early on in life that the families and even next 2 generations would more than survive in their absence! Still, HNIs pay crores of rupees in insurance premiums annually for policies they do not require and which otherwise could be channelized into investment options which earn better returns. However, it does not really make a difference to their financial situation.

On the other hand, in the case of my good friend,  his decision to buy an expensive insurance cover only to discontinue it five years later costs him an opportunity to save more and invest more for the down payment of his new house. Also, the surrender value which he will now receive after discontinuing the policy will be far lower than the total premium paid.

Now picture this. Had my friend bought a pure term insurance cover five years back instead of an endowment plan, he would have paid an annual premium of Rs.2,180 for the same cover of Rs.8 lakh. So he would have saved about Rs.41,555 (43735-2180). Had he parked the savings on premium payment in a bank fixed deposit (assuming 8.5 per cent return p.a) and utilized it for the down payment of the house, he would have taken Rs. 2.67 lakh less loan. The number may appear small in present value for just one year but grows big after the effect of compounding for the entire loan tenure. 

On a lesser loan of Rs.32.3 lakh (35-2.67) he would have saved 3.8 lakh interest during the loan tenure! Further, the money saved on interest every year could have been invested in suitable avenues and would already have started generating additional income for him. (Refer to the table for the entire calculation)

As observed above, every financial decision is likely to have a bearing on other areas of personal finance. Secondly, the repercussions of financial mistakes are felt over a really longer period of time and it hits hard in the long run when an individual, particularly the average salaried class, falls short of funds to achieve his financial goals like children education, retirement, etc.

Here is a snapshot of some common financial mistakes usually committed and their possible consequences:

So what should one do to avoid mistakes or at least take quick action to minimize their impact?

Most people do not have the time, inclination or the knowledge to do the due diligence before committing their money in various financial instruments. They have no inkling what are they saving for and how much saving is sufficient to meet the desired goals.

There has to be a basic level of involvement required in personal finance matters. This implies not leaving buying of financial products entirely to your brokers, distributors, bankers, relationship managers, agents, friends, relatives, etc and be involved only in signing papers and issuing cheques. While we invest so much of our time everyday to earn money, we need to invest time to take decisions to manage that hard earned money as well. This particularly includes buying any financial product - equity share, mutual fund, insurance, pension policy, etc. 

We are fortunate to be living in an information age where huge amounts of simple & easy to understand content on personal finance is available - be it newspapers, blogs, websites and that too absolutely free. For more comprehensive solutions, we have certified financial planners who offer quality advice to people without the thrust on product selling and earning fat commissions. Even second opinions can be taken with other financial experts like we take in the case of medical issues from doctors. Ultimately, it all boils down to how involved one is in personal finance matters. One need not be a super expert on every aspect of managing finances but at least some basic acumen to a reasonable extent should be gradually developed so that financial mistakes can be avoided. Financial Literacy is the key here!

Cheap premium should not be the sole

reason to choose an online term insurance

plan

 

With the increasing internet density in India, it has become possible to buy financial products online. This ranges from equity shares, mutual funds and now life insurance. This article deals with online term insurance plans.

Insurance companies are advertising online term plans in a big way. I compiled premium data of few insurance companies offering online term plans and found the rates very competitive. The huge price war in this category has resulted in companies like Aegon Religare, Bharti AXA and Aviva offering life insurance for as low as Rs.4,500-5,000. And, these online term plans come at less than half the cost of the traditional offline term plans.

 

 

Note: Premium Cost Data compiled from Company Online Calculators and inclusive of Service tax, exclusive of additional riders

This low premium is on account of three reasons:

•  No agent costs involved in the absence of an intermediary, i.e., you will directly buy the term plan from the life insurance company.
•  Low operational costs such as storage of forms and data entry.
• Profile of online customers perceived to be carrying low mortality risk as they have the resources for better healthcare and lifestyle.

 

Most term insurance products more or less bear the same features, the only distinguishing factor being the premium cost and customer service. While some buyers may have a bad experience with a particular company, there may be an equal number, if not more, who would have a good hassle free experience with the same company.  So should you buy a term cover based only on a comparison of premium cost?  The ANSWER is a big ‘NO’.  There are many other factors which need to be assessed in conjunction with low premium. In fact, once you shortlist any term plan based on the factors discussed below, then you can compare them further in terms of premium cost.  These factors have been addressed below in detail:

 

1. Claim settlement ratio (CSR): This should be the starting point in selecting an online term insurance plan (or for that matter any insurance plan). If the claim is rejected by the insurance company, the whole purpose of taking insurance is defeated and your family members will be deprived of financial security which you had planned for them. A poor claim settlement ratio (CSR), (40% would mean that 4 out of 10 claims are settled and the rest are refused) would imply that a company does not pay its customers when claims are made.

 

Typically, older insurance firms will have better CSR than the new insurance players. As seen in the table below, LIC, ICICI Prudential and HDFC Standard Life have the highest claim settlement ratio of 97 per cent in 2011-12.

  

 

 

Source: IRDA & Company Wesbite

Early claims made within 2-3 years of buying a policy are rigorously investigated by insurance companies and hence take time in the settlement process (as long as six months). So new insurance companies who have set up shop in around 2009-10 would obviously have claims made within three years of buying the policy.

 

I analysed the repudiation ratios of all 23 life insurance companies for cases greater than 2 years of policy buy. Of these, Shriram (founded in 2007) had the highest repudiation ratio of 31 per cent in 2011-12. This means that of all the claims rejected by the company, 31 per cent were related to cases of greater than 2 years. Its claim settlement ratio in 2011-12 was 65 per cent.

So, in case you come across a company which has been around for at least five years and still has not consistently improved its CSR year-on-year, then it should be a cause for concern. It may be charging very low premiums vis-a-vis its peers but would have a poor claim settlement history. So preferably choose a company which is in the life insurance business for at least five years since its inception and has a high CSR.

 

More importantly, it is also your responsibility to disclose

• your complete medical information
• smoking & drinking habits, if any
• other life insurance policies that you hold

 

If you fill in the online application sincerely and meticulously, there is a good chance that your claim will not be denied.

 

2. Coverage:  Choose a company which gives you the maximum coverage in terms of age. It is prudent to buy a life cover which would insure you at least till the period you retire, i.e, 60 or may be more. For instance, say you buy a life insurance product at the age of 25 and the product has a maximum covering term of 30 years. In that case, your life insurance contract will expire at the age of 55 and you will be left short of 5 years of insurance coverage as you would still be working then.

 

Further, financial responsibilities may not end at 60 in the case of late marriages and having children at a higher age.

Many online term plans come with fixed tenures of 15, 20, 25 and 30 years. There are few companies which offer coverage till the age of 75 while others do not insure you beyond the age of 60. So it is best to opt for a policy that can be customised to your needs.

At the end of the day, what matters to you is your family’s security. Just to save a couple of thousands every year, you do not want to risk your family’s financial requirements in the event of the insurance company rejecting their claim at the most critical time. So shortlist life insurance companies by checking their claim settlement ratio and coverage rather than just comparing their premium costs.

 

 

Assess the risks, not just the benefits in continuing home loan at a lower rate

Few weeks back, I had covered an article on home loan titled ‘Prepay your home loan in small chunks and reduce your liability’.

Conventional wisdom states that one should pay off home loan as fast as possible and become debt-free. But I have come across a section of people who find it beneficial to continue their home loans! Such financial decision is guided by the following logic:

• If the investment rate is more than the rate of interest charged on the loan, i.e, if the return on investment is higher than the interest paid on home loan, then it is beneficial to continue the loan and invest the surplus amount in high yielding options.

• Under S/24 of the Income Tax Act, interest paid on home loan is allowed as deduction from total income up to a maximum limit of Rs.1.5 lakh per annum.

But are these benefits worth enough to live on debt for a roof which you can’t claim your own for a major part of your productive working life?

I am not going into the calculation part in this article but there are a few issues here which I would like to highlight.  

This strategy is unlikely to work for borrowers who take such financial decisions for a short term on an ad hoc basis depending upon the attractiveness of investment options in a particular year. It will not work for the simple reason that interest charged on home loan is compounded on a monthly basis, so the effective interest rate is higher.  On the other hand, most fixed income investment options like fixed deposit offer returns on a compounded annual basis and hence the difference compared to the interest rate would not be much. Rather than repaying the loan, investing the surplus funds in equities with a short term horizon is also risky. So a borrower is better off to repay the loan in the initial years as the interest component is huge.

Now, let us assume the case of a borrower who had taken a home loan at fixed rate of 8.5 per cent per annum few years ago. He adopts the strategy of delaying his loan prepayment and instead builds an investment corpus to pay off the liability at the near end of the tenure.

Even if the investment returns are high over a longer period of time than the interest paid, this approach may prove to be a risky proposition. The borrower needs to have a fundamental understanding of the following issues:

 1. Evaluating safety net: 

This involves assessing one’s security and well-being in the event of a worst case scenario like loss of job or death of the bread earner in the family saddled with debt. The borrower needs to address the following questions:

• What if I lose my job tomorrow? Will I have the capacity to repay home loan alongside my normal household expenses?
• If I am physically incapacitated, partially or completely by any accident, will I have the capacity to repay home loan?
• If I cannot repay my home loan in the event of job loss or some unfortunate incident which affect my capacity to earn regular income, do I have a second home to live in? Am I left with no alternate option but to sell the house? 
• What if I am not available for my loved ones tomorrow? Have I bought insurance cover to cover for the repayment of loan liability? If not, how will my loved ones manage to repay the loan.

2. Understanding the difference between asset and liability:  

While doing a cost-benefit analysis of the investment returns vis-à-vis home loan interest payment, some people also take into account the appreciation in property prices. They perceive that if the property being bought on loan has appreciated more than exponentially compared to the interest paid during the tenure, there is no harm in continuing the loan at a lower rate and pay interest on it.

Most people do not understand a fundamental fact which is that the capital gains on property is notional unless it is bought as an investment asset and planned to be liquidated eventually. On the other hand, interest paid on home loan is for real and goes out of the personal pocket every month.

The house that is self-occupied can never be an asset, it is a security for a roof over the borrower’s head. When it comes to personal finance matters, an asset should be perceived as an item which generates additional income. On the other hand, the house is a liability and will remain with the bank as mortgage unless and until the entire loan is paid with interest. 

Conclusion: Giving priority to repayment of the home loan does not mean one compromises on other financial goals. Usually, an individual typically takes a home loan near his 30s. After servicing the EMI, he also needs to save for his next logical goal which is children’s education. As a borrower’s income increases, he can repay his loan in small chunks and along side divert a small sum to investments.

The general human tendency when faced with many choices is to opt for a solution which gives the maximum benefit. But one also needs to analyse what kind of risks, if any, are being undertaken to achieve that benefit. It is prudent to take calculated risks in life, particularly in financial matters. At the end of the day, we are all yearning for financial security which can give us peace. No one wants to spend sleepless nights worrying about some mountain of debt. So it is advisable to review one’s financial situation in totality because a financial decision can never be sound until it offers mental peace.