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Learn the smarter way, apply rules of thumb

Audience: All

Purpose: Get smarter in money planning

Source: The Hindu, New Delhi, March 28 2007

Nature of Blog: Abridged version of the orginal article

Reason for documentation: My notes/Knowledge sharing

Here are a few commonly used rules of thumb categorised into mathematical rules and financial advisors' rules.  

Mathematical Rules: 

a) Rule of 72 - This rule (written as 72/r) helps one determine the number of years it will take to double money, where r is the annual compounded rate of interest. If a bank offers you 8% p.a. compounded annual rate, then you can expect your money to double in approximately 9 years. 

b) Real rate is twice 'flat rate' - Many agents sell loans at a rate which appears mouth watering. But look closely and the fine print will say that the calculations are based on flat rate. Flat rate means that the interest is linearly (or simply) calculated, rather than on a reducing balance method. 

For e.g. If you take a five year (60 months) or auto loan of Rs. 3,00,000 and the EMI is, say, INR 6,335, then the total payment will be 6,335*60 months = INR 3,80,100 implying that the interest paid is INR 80,100 over the next 60 months. 

The wrong (or the flat method) of calculating interest is to say that the annual interest paid is INR 80,100/5 years = INR 16,020, and hence the interest rate is 5.34% (INR 16,020/INR 3,00,000*100). 

If you calculate the interest based on the reducing balance method, which is what banks actually do, then the real rate of interest works out to 10.18% which is roughly twice (10.18/5.13 = 1.91) the interest rate that the agent will tell you. It is mathematically true that the real rate is approximately twice the flat rate. 

Financial Advisors' Rules

These rules help the advisor in devising a strategy for you. 

a) Term + Mutual Funds > ULIPs: Bundling insurance and investments is typically not a very good idea. A ULIP can be deconstructed into a term plan (pure risk cover) and an investment portion. Buying a term plan with the insurance company and investing a balance amount into a choice of mutual funds will typically yield you a better performance. 

b) Debt outflows should be limited to 50% of your income - You would have noticed that banks offer loans up to 48 times your monthly salary. Have you wondered why? Let us see: If you take a loan at 10.5% interest for 20 years .... (this part is incomplete.. i need to first understand the EMI) 

EMI? 

The present value factor for annuity for n periods, PAF(r,n), is: 

PAF(r,n) = 1/(1+r) + 1/(1+r)^2 + 1/(1+r)^3 + ........ + i/(1+r)^n

   = 1/r [1 - [1/{(1+r)^n}]]

Therefore present value of an n year annuity is 

PV = C * PAF(r,n) 

where PV = present value or the loan amount

C = EMI

r = rate of interest

n = number of years

Ok, so calculating by the above formula, the EMI i.e. the value of C is approx. 12K per annum i.e. 1000 per month. 

Assume that your monthly salary is INR 10K. Banks, following this rule of thumb, will expect that you can pay upto INR 5K as EMI. Hence, they can offer you a loan upto INR 5,00,000. Incidently this amount is approximately 48 times your monthly salary!

If the bank realises that you are paying EMI on other loans (like Car or Education Loan), they will reduce the quantum that you are eligible for such that not more than INR 5K of your income is used towards debt servicing. 

Milan 

6:09 pm GMT

The ABC of Financial Planning

Audience: All

Purpose: Understanding the key steps to Financial Planning

Source: The Hindu, New Delhi, March 4 2007

Nature of Blog: Abridged version of the orginal article

Reason for documentation: These are my important notes that help me in Financial Planning. If anyone wants to read for information or knowledge, he/she is most welcome to do so either from this blog here, or from the archives of original source. 

Astute long term planning may make life financially secure, while inadequate or misguided planning may make it awry. Meet your life's goals through prudent management of finances i.e. 'Financial Planning'. Financial Planning covers the various facets of individual's financial needs, which includes: 

a) Accumulating capital - Cash flow planning and budgeting. 

b) Protection against Risk - Insurance planning and risk management. 

c) Investment Planning - and advice. 

d) Estate Planning - Wills and trusts. 

e) Retirement Planning

f) Tax Planning 

You have to start by understanding what are your goals for the future, where do you see yourself financially after 5 years, after 10 years, or after retirement. Once you have realised your goals, you have to put a sound plan in place and follow it. Here are the six basic steps: 

Step 1: Establish your goals - Think long and hard about what you want to accomplish in life - your current status and future potential of your earnings. 

Step 2: Gather data - Start by collecting all your bank and brokerage statements, insurance policies, real-estate documents, and maybe even your most recent tax returns. List your assests and liabilities. You will also need to gather records of all your sources of income and expenses, and anything else you can think of that is related to your finances. 

Step 3: Analyse the data - At this stage you will create a personal net worth statement and a statement of annual cash flows. You will also analyze the adequacy of your estate plan and insurance coverage. As the picture develops, specific shortfalls or excesses will come into focus, along with areas you need to change. 

Step 4: Create a plan - Now you are ready to lay the roadmap that will help you accomplish your goals, given your risk tolerance and time frames. Your plan may call for immediate changes, such as diversifying your investments, shifting your asset allocation, consolidating accounts, optimizing your insurance coverage, or drafting wills and other estate planning documents. Your plan may also call for longer-term actions such as altering your spending and saving habits over time. 

Step 5: Implement your plan - Suitability and performance hold the key here. Remember you can potentially boost the income of your long term investments by keeping cost and expenses as low as possible. Also, take advantage of available tax-free and/or tax-deferred accounts, in addition to your regular taxable brokerage account. 

Step 6: Monitor your plan - This involves keeping an eye on the performance of your investments, periodically rebalancing/churning your portfolio. In the absence of major event in your life, once or twice the year should do it.

 

Milan 

3:58 pm GMT

P.S. The most important is that every now and then revisit the plan and keep a status check on the growth. Life keeps throwing curves now and then, hence a constant monitoring is absolutely essential to ensure that you are on the correct path and at the correct momentum. 

Computing Tax Exempt portion of your HRA

Audience: Indian TaxPayers 

Purpose: Understanding the provisions and implications of House Rent Allowance

Source: The Economic Times, New Delhi, February 21 2007

Nature of Blog: Abridged version of the orginal article

Reason for documentation: These are my important notes that help me in Financial Planning. If anyone wants to read for information or knowledge, he/she is most welcome to do so either from this blog here, or from the archives of original source. 

The exemption applicable to house rent allowance (HRA) is covered under Section 10 (13A) of the Income-Tax Act. Normally it is part of the salary package over and above the basic salary and dearness allowance (if any). And, HRA is given irrespective of the end use of funds. Now, whether or not one gets excemption on the HRA is subject to various conditions. 

The foremost condition for claiming exemption on HRA are - you must pay rent for the rented premises which you occupy, but you must not own the rented premises and that the rent should be more than 1o% of your income. 

How is the tax exempt amount calculated? 

The I-T Act describes the process by which the amount exempt from tax is to be calculated. As per the relevant provision, the least of the following is exempt - house rent allowance received; rent paid less 10% of salary and 40% of salary (50% in case of Mumbai, Chennai, Kolkata and Delhi). Salary here means bonus + dearness allowance(DA) where provided by the terms of employment. 

Usually, private sector employers do not pat DA to employees. "Most companies keep HRA as 40% or 50% of the basic salary of their employees to make the salary structure efficient", as said by Adroit Services, Pune. 

For e.g. - 

If you earn a salary of INR 40K, and the house rent allowance is INR 20K (50% of your salary). Let us assume that you pay a rent of INR 15K for an accomodation at Mumbai. In such a case, the amount of rent paid minus 10% of the salary works out to INR 11K, while 50% of the salary is 20K. The least amount as per the Income Tax provisions is INR 11K. => This is the amount that is exempt from Tax, the balance amount of INR 4K will be taxed. 

When can you claim exemption?

You can claim rent given to parents if you live with them. This,technically, makes your parents the landlords. Then, one of your parents' should declare it in his/her personal income-tax return to prevent litigation in the future. However, you cannot claim rent paid to spouse, because the relationship of husband and wife is legally not declared as of commercial nature, whereby they are supposed to live together. 

Documents needed - 

Employers follow varied policies regarding the documents they collect. Some insist for rent agreement and bank statement extract while some just ask for plain receipt. 

The general practice is that corporate require employees to show the rent agreement and the rent receipts with a revenue stamp affixed on the receipts and the signature of the landlord crossing the revenue stamp. Although you have to produce rent receipts for claiming deduction under Section 10 (13A), salaried employees drawing house rent allowance up to INR 3000 per month are exempted from production of rent receipts. 

However, this concession is only for the purpose of tex deduction at source, and in the regular assessment of the employee, the assessing officer can make enquiries. If you receive HRA for the period during which you were not occupying a rental accomodation then you would not earn exemption. 

Some companies insist on additional information and disclosures such as landlord's PAN number though this is not mandated by the income-tax department. In such cases, employees have the option to claim  HRA exemption at the time of filing tax returns if the landlord is not prepared to give his PAN number. 

Home Loan and HRA Benefits

Q. Can i get a cliam exemption on HRA and also claim deduction on account of Housing Loan Interest and principle at the same time? 

Ans: Yes this is possible, however under certain conditions: 

a) If you took a home loan to buy a house in Mumbai, but you reside in Bengaluru for some reason, you can get a tax benefit on principal repayment, as well as interest repayment (under Section 24 HRA benefits 10 (13A)). Thus, if the rented accomodation and the owned houses are in different cities, this indeed is possible. 

b) Suppose you have bought a house in the same city but you are staying in a rented accomodtaion because your owned house is not yet ready for possession, you may still be entitled to HRA benefits. 

c) It may happen that your house and work place are in the same city, but you still take a rented accomodation because your house is distant from your office. In such a case, you can still avail of HRA deduction under Section 10(13A). A tax rebate upto INR 1,50,000 under Section 24 on home loan interest and a tax relief upto INR 100K under Section 80C can also be awailed. 

d) If you took a house loan, got possession of the house, have rented it out and stay in a rented accomodation, you will be entitled to all the tax benefits mentioned above. However, the rent you earn on your house would be taxable.

e) It may not be possible to claim HRA exemption, if both the houses are in the same locality. Your home must be at a considerable distance for you to stay elsewhere and claim HRA exemption. If your house and the rented accomodation is in the same vicinity the HRA benefit would stop once your house is ready for possession. 

Milan

00:28 am GMT