INVESTORS PLEASE LISTEN !: Knowledge cafe

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Monday, March 16, 2009

[Investors Please Listen] Understanding your Home Loan Offer - Flat loan rate VS Reducing balance loan

For the twins, Gayathri and Sanjana, fate intended that everything in their lives should happen in unison. Be it their first visit from the tooth fairy or their first job, the precision in timing was astounding.

It so happened that they decided to buy their dream homes too around the same time.

The destiny that bound them together did not apparently bind their natures as Gayathri was very laid back and did not care too much for numbers, so she approached the first friendly bank that treated her like a queen, when she applied for a loan and took their best offer.

Sanjana on the other hand did her research and had offers from several banks.

Back at home Sanjana compared notes with Gayathri, who almost jumped for joy. She felt that she had landed an excellent loan bargain with minimum fuss, unlike her sister.

After all, for the same loan amount of Rs 20 lakh (Rs 2 million) with a 20-year loan tenure, Gayathri had an annualised interest rate of 12.75 per cent, while the two loans that Sanjana had shortlisted from a bunch of loan offers, were both quoted at an annualised interest rate of 13 per cent!

However, Gayathri's joy was short-lived when Sanjana explained how appearances can prove to be deceptive!

The loan offer Gayathri obtained was a flat rate loan. Banks can calculate their interest rates either at a flat rate or a reducing balance rate. Sanjana on the other hand, had shortlisted two reducing balance loan offers with different rest periods.

As her calculations revealed, the loan offer with a monthly rest turned out to be a better loan bargain than the one with an annual rest. Let us examine these two aspects stated above in detail.

At a flat rate, the interest rates are calculated keeping the outstanding amount (i.e. the amount on which interest is calculated) constant throughout the loan tenure, while in a reducing balance loan the interest rate is recalculated on a periodic basis based on the reducing outstanding loan amount.

Sanjana explained to Gayathri that at any given point in time, an X per cent flat rate is always more expensive than an X per cent annual reducing balance rate. Even in the case of a reducing balance loan a significant factor that impacts the loan cost is the time interval at which the reducing balance is recalculated, which could be monthly, daily, yearly, quarterly or half yearly.

These time periods are known as rests, which denote the regular interval at which the loan amount balance is recalculated and also refers to the periodicity of compounding. This can be possible only in the case of reducing balance loans.

The table below has the results of Sanjana's calculations that helped Gayathri calculate the real cost of her loan.

Loan type	A	B
Loan type	Gayathri's Flat Rate Loan	Sanjana's Reducing Balance Loan
Annualised interest rate for a Rs 20 lakh loan with a loan tenure of 20 years	12.75%	13.00%
Type of Rest	Does not apply	Annual Rest	Monthly Rest
EMI	Rs 29,583	Rs 23,726	Rs 23,432
Total interest paid	51 lakh	36.94 lakh	36.23 lakh

Flat rate loan versus reducing balance loan

In the above table, a comparison between Column A and B reveals the difference in the impact between a flat rate loan and a reducing balance loan.

It is clear that the effective interest that Gayathri will need to pay up with her current loan offer is much higher amounting to Rs 51 lakh (Rs 5.1 million), while the loan offers Sanjana had zeroed in on for the same loan amount and tenure was much lower showing a difference of nearly Rs 20 lakh in the interest paid out!

Choosing the offer with the ideal 'rest'

To make the most of your reducing balance loan you need to ensure the periodicity of repayment closely matches the frequency of your rest.

Sanjana was quick to realize this and her calculations revealed that a yearly rest or an annual rest would mean that even when you pay EMIs on a monthly basis on your loan, the loan amount based on which you pay the interest, will be recalculated only at the end of the year (12 months).

This means you would continue to pay interest on the entire loan amount till that particular year (compounding period, when the outstanding loan amount is recalculated) ends, even when the outstanding loan amount reduces each month.

In the case of a monthly rest, the balance loan amount is recalculated and decreases every month. Hence it is to the advantage of Sanjana to take up a loan offer with the rest that more closely matches the frequency of her loan repayment.

So if you are repaying your loan amount on a monthly basis, take up the loan offer that gives you the best rate on a monthly rest.

Banks generally quote an 'annualized' interest rate, but remember that interest rates can be deceptive unless you figure out how they are defined. You can easily calculate the total amount of interest that you will pay for each offer by multiplying your EMI into the number of monthly installments and subtracting the loan amount from this figure.

You can then easily identify which loan is the most cost effective for you. Remember to account for any upfront fees (e.g. processing fee) while comparing two loans.

In summary, the key to understanding your loan offers from multiple banks is to calculate the total amount of interest and fees you would pay for each offer and zero in on the offer that gives you the least total interest outflow.

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Housing gains through Tax incentives

16 Mar 2009, 0511 hrs IST, Bakul Chugan, ET Bureau

Investment begins at home. Though the real estate sector has seen a deep correction, a house is probably one of the best investment avenues one can

seek today. Despite the global economic slump, which has hit the property prices too, real estate still remains a prized possession.
If falling interest rates and cooling off property prices are prompting some to take a leap and grab their dream houses, there is also no dearth of those who want to sell their house to overcome the recession blues. And, given the importance attached to this most prized asset class, taxman has provided tax incentives for both the buyer as well as the seller of the house.

Buying A House
If your dream house has now come within your reach, check out the following before taking the plunge. (a) It is always advisable to go in for a home loan. Interest paid on home loans can be deducted from your taxable income up to a maximum of Rs 1.5 lakh.
As this deduction is applicable to each individual owner of the house, this can be a double bonanza in the case of joint ownership. Thus, if the joint owners equally bear the interest burden, then each owner shall be eligible for a deduction up to Rs 1.5 lakh
However, it is important to note here that where more than one owner claims deduction, the total deduction cannot exceed the actual interest paid by the joint owners.
For example, if the annual interest liability on the house property is Rs 2 lakh and the property is jointly owned by husband and wife, then each gets a deduction of Rs 1 lakh only.
Similarly, where the annual interest liability is Rs 4 lakh, then each owner gets a deduction of Rs 1.5 lakh only, taking the total deduction to Rs 3 lakh (b) It is not only the interest repayment but even the principal re-paid can be claimed as a deduction under section 80C. The limit here is restricted to Rs 1 lakh provided the loan is borrowed from a recognised financial institution

Owning More Than One House
It is not unusual to see people own more than one house these days, especially by those who like to invest in real estate. It has in fact become a common practice to buy and let out houses, which also adds substantially to one’s income, given a high demand for rental premises.
If the subsequent houses are also purchased through borrowed finance, the entire amount paid as interest can be claimed as deduction from taxable income. Ceiling limit of Rs 1.5 lakh is not applicable in case of subsequent properties as these are deemed to be let out.
Thus even if the same are vacant, the owner shall be required to disclose a notional rental income that the property would have derived had it been actually let out.

Selling A House
Selling a house is rewarding - from tax perspective - provided the same is held for at least for three years before transferring the title. Holding a property for three years and more makes it a long-term capital asset and eligible for various tax incentives under the Income Tax Act.

Gains arising from the sale of a house are treated as income and are thus taxable in the hands of the seller of the property. However, if the sale proceeds are utilised for either buying or constructing another property, the same shall be exempt from taxes.
However, one needs to keep in mind the following to avail of these tax incentives. (a) If the new house is intended to be bought, the same should be purchased one year before or within two years of selling the existing property
(b) However, if the new house is to be constructed, ensure that it is done within three years of sale of the earlier property. It is not necessary to begun construction only after selling the earlier property. However, the construction must be complete within three years of sale
(c) For the interval between the sale of the existing property and buying or constructing another property, the sale proceeds need to be deposited in the ‘capital gains deposit account scheme’ with any nationalised bank. The proof of this deposit should be submitted along with the return of income to claim an exemption from capital gains tax
For those who do not wish to acquire another house from the sale proceeds of the existing property, capital gains tax can be avoided by investing the sale proceeds in the capital gains bonds issued by NHAI or REC within six months of sale of the property. The maximum investment permitted in such bonds is Rs 50 lakh, and these bonds can be redeemed only after three years from the date of investment.

Rental Accomodation
Tax incentives are available not only for the owners but also for those who have rented accommodations. In case of salaried employees who receive a house rent allowance (HRA) from their employers, the least of the following three options can be claimed as an exemption under section 10(13A): (a) HRA actually received from the employer (b) Rent paid in excess of 10% of the salary (c) 50% of the salary (metros) or 40% of the salary (non-metros).
In case of self employed individuals or those employees who do not receive an HRA, the least of the following three options can be claimed as an exemption under section 80GG: (a) Rs 2000/- per month (b) 25% of the total income (c) Rent paid in excess of 10% of total income.

HOUSEWISE
Sell a property only after holding it for at least three years
New house property should be purchased one year before or two years after sale
Construction of new house ought to be completed within three years of sale
Deposit sale proceeds in capital gains deposit account scheme till the time of new purchase
Capital gains can also be used to purchase bonds from NHAI or REC
Buyers would do well to take a loan to finance a house
Joint ownership is always advisable if you are borrowing money for house property

Saturday, January 24, 2009

Tax Saving Investment Declaration

Health Cover Basics

Saturday, December 27, 2008

Lessons from 2008

Five mistakes that you should not repeat in the coming year.

For many investors, 2008 was a nightmare that came true. After four years of boom, when the tables turned, it wiped out lakhs of crores of investors' wealth.

Last December, there would have been a smile on everyone's face. While the US had started feeling the pinch of the sub prime crisis, many experts claimed that India was decoupled from what was happening there. Well, it took just one month to change the scenario.

On January 21, in a matter of hours the benchmark indices, Sensex and Nifty, hit the lower circuits. And in the next 11 months, there have been few moments of pleasure for the stock market investor. Both the indices are down over 50 per cent. But depending on portfolio, some investors have even lost 80-85 per cent.

As the year-end approaches, let's look at some of the mistakes that many investors made during the last year and hopefully, refrain from making them again.

OVER LEVERAGING: Buying stocks with borrowed money is leveraging. And it is a crime that many investors committed last year.

Typically, a broker either lends or allows the investor to have a larger position than the money that has been deposited. The interest rate on such lending is higher. Consider this, often an investor has Rs 1 lakh and has positions in the market four to five times of that.

When things are good and stock prices are rising to dizzying levels, everyone is happy. The return on investment outstrips the interest cost. But when the market falls, it is a complete disaster.

For instance, when Reliance Industries was trading at Rs 2,500, you bought stocks worth Rs 4 lakh on an initial capital of Rs 1 lakh. If the stock moves to Rs 2,700, it has gone up by only 8 per cent, but the return on investment (Rs 1 lakh) is 32 per cent.

Now if the stock dips to Rs 2,000, down 20 per cent, you stand to lose 80 per cent. Now if you add the interest cost to the total capital loss, then the initial capital might have been wiped out.

LESSON: Multiplier effect has both sides. Use the loan facility very responsibly and with stringent limits to it.

AVERAGING EFFECT: Whenever stock markets start falling, the initial reaction from investors is to buy more. The idea being that there would be cost averaging.

However, when a slide like this happens, this should be the last thing on your mind. It's because while you may have brought down the acquisition cost, a lot of money has gone into this process. It is almost like throwing good money after bad money.

Often, this happens when one refuses to believe that things are turning sour and the recovery would take a long, long time.

LESSON: Emotional attachment to a stock can be very damaging. If you have made the mistake of buying shares at higher price, don't multiply it by buying them at every low.

INVESTING ON TIPS OR RUMOURS: Many investors can be accused of this one. But things can go real bad sometimes. This is especially true with mid- and-small-cap stocks.

There are hundreds of examples where tips are given for penny stocks or Z category stocks. Initially, it may give you some money. In the long run, however, such investing tactics can be fatal.

LESSON: Just ignore.

DERIVATIVES PLAY: For a lay investor, this is a definite no. As investing guru Warrant Buffet had once said, derivatives are 'financial weapons of mass destruction'.

A large number of small investors used the derivatives route to invest rather than the cash segment. It was easy since futures and options allowed them to take positions on either side (long or short) with little over 20 per cent margin or little option premium.

But since they have to pay only 20 per cent, bigger risks are taken. That is, small losses are not booked. Instead, positions are rolled on in the hope that ultimately things would favour them.

No wonder, losses keep mounting and can really hurt sometimes. For example, it is better to buy futures at Rs 25 and book profits around 25.5 or 26 levels, effectively earning 10-20 per cent return on the margin amount. However, keeping the position open even while losing can be disastrous.

LESSON: Derivatives are not an investment tool but a hedging mechanism. So either don't use it or use only after you equip yourself with its pros and cons.

IPO INVESTMENT: On an average, during boom times, initial public offerings (IPOs) of companies are oversubscribed by 40-50 times. As a result, investors use the IPO route to make quick money.

That is, on the day of listing they simply book profits. For many, it is a sure shot mantra for quick money.

But when the scrip lists lower than the offer price, getting stuck is very much possible. And if someone has taken a loan and applied for the IPO then things could get real bad. Investors who invested using IPO funding facility get hurt the most. Long-term IPO investors may still make a decent return over a long run, but subscribe and sell on first day is out of sight at the moment.

LESSON: Invest in IPOs only when you believe in the company. Otherwise, just stay away.

Investors should realise that making money is a long-term process. However, in their attempt to make a quick buck, many suffer. In 2009, make sure that these mistakes will not be repeated.