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