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Four financial thumb rules to follow

india Updated: Oct 28, 2011 21:24 IST
Bindisha Sarang

They say when your values are clear to you, making decisions becomes easier. The maxim also works when it comes to making financial decisions. Here are some time-tested financial thumb rules pertaining to borrowing and investing in fixed deposits. However, there are several other thumb rules for various financial decisions.

Rule I
While borrowing, monthly rest is better than quarterly and quarterly is better than annual.

When you take a loan, the most important parameter to look into is the rate of interest. Then there are fees such as processing and pre-payment charges, loan tenor and the like. Let’s assume that you have an option to borrow from two different lenders and all the parameters are the same. How would you choose then?

The word “rest” is used in the milieu of a reducing balance loan. Rest describes the periodicity at which the principal amount is reduced as you repay the loan. Rests are usually monthly, quarterly and annual.

How it works: A monthly rest takes into account the reduced principal after each equated monthly instalment (EMI) and accordingly applies the interest rate on the reduced principal. If the rest is quarterly, the repaid principal amount is adjusted every quarter and so on.

For instance, if you borrow Rs 5 lakh at 12% for 20 years, the total interest you pay on a monthly rest clause is Rs 8.2 lakh. You pay Rs 8.2 lakh on quarterly rest and Rs 8.4 lakh on annual rest.

Rule II
Not more than 30-35% of income.

An average urban family today has two to three loans — such as loans for home, car and consumer durables — going at a given point of time. But while taking loans has become easier, repaying them could become a problem and you may not even realise when you slip in a debt trap. So ensure your borrowing should never exceed 30-35% of your income. This means that if you earn R100 per month, your EMIs should not exceed Rs 30-35 a month.

“About 30% of monthly income as EMIs for all debt is ideal,” said Kiran Telang, CFO, ABT Capital Advisors, Mumbai-based financial planning firm. “Anything more than that could cause trouble.”

Rule III
Remember the ratio 20:4:10 when taking a car loan.

Most people buy a car on loan and this ratio would be useful in making a decision.

In this ratio, 20 (or more) stands for downpayment, ensuring that you have paid a substantial amount initially, which will decrease the overall cost of your loan.

Then, 4 stands for the tenure. While banks may offer you a car loan for up to seven years, it’s best to stick to a four-year tenor or less.

“The longer the tenure of the loan, the higher is the total cost of the loan; the sooner you get rid of the loan, the better the deal,” said Ranjit Dani, a Nagpur-based certified financial planner. That way not only does the total cost of the car goes down, you also get to own it sooner.

The last figure in the ratio, 10, stands for the percentage of your monthly income you should shell out for your car EMI. Your car EMI should not exceed 10% of your monthly income.

Rule IV
Higher the compounding, more the amount of future value.

When you make an investment, the instrument quotes the nominal rate of interest. But that may not necessarily be the rate of interest which you would actually earn. Your earning depends on the type of compounding applied, so your effective rate is the annual rate of interest that accounts for the effect of compounding. A rate can compound monthly, quarterly, semi-annually or annually.

Let’s assume you invest Rs 50,000 at 12% for a year. If the instrument compounds the interest on a monthly basis, your R50,000 will grow to Rs 56,341; if the instrument is compounded quarterly, you will get Rs 56,275; with semi-annual compounding, you will get R56,180; and with annual compounding, you will get Rs 56,000. This clearly shows that the shorter the compounding frequency, higher would be the future value of your investment.

Following these general thumb rules will help you make informed decisions.