Avoid your own financial crisis
Manu Kaushik October 16, 2008Most investors have been too psyched out by the mayhem in the global financial markets and its crippling impact on their investment portfolios to take note of the lessons that the crisis holds for them—that poor decisions can land anyone, from large organisations to individuals, in a financial mess, and that this doesn’t take long to happen. For individuals, financial crisis can result from excessive borrowing, living beyond one’s means, poor asset allocation, under-diversification, medical emergencies, or even loss of employment. And it’s in deteriorating market conditions such as at present that individuals are made to pay dearly for such follies. Ergo, it’s important to work out a plan to stay in control and avert a financial crisis. Here’s what you should do.
Know your debt
We all need debt at some point. It can be a loan for a house, an automobile, education, or for other personal needs. But debts can be good, bad or ugly. Home loans are considered good debts as they are used to build useful assets. A home loan makes more sense if you want to switch from a rented to an owned house. And, the lesser the difference between your EMI (equated monthly installment) and rent, the more sense it makes to acquire a home. Says Sanjay Matai, Promoter, The Wealth Architect: “From the need perspective, it is prudent to borrow only for good loans and not to exceed certain limits.” Personal loans are “bad” debts, which should be availed of only in dire circumstances. Ugly loans include credit card debts that are used to finance consumption or luxuries. Both these loans come with high interest rate liabilities and should be avoided at all costs.
Financial planners suggest that one should remain as debt-free as possible. If it’s entirely necessary, then one should borrow only to the extent one can comfortably. Says Viraj Ghatlia, Head, Financial Planning & Wealth Advisory, ASK Wealth Advisors: “When you borrow, you must compare the period for which you take the loan and its repayment schedule with future cash inflow projections. The inflows should always be far greater than the outflows since there can be other expenses besides servicing the loan.”
Normally, the size of down payment and EMI determines whether one can afford a loan or not. If you are taking a home loan, then look for a property for which you can make the down payment, which is usually 15 per cent of the cost of the property. Thus, you can go for a Rs 50-lakh home if you can pay Rs 7.5 lakh. Also, the home loan EMI should not exceed 40 per cent of your net take-home pay. In case of personal/credit card loans, the EMI should not exceed 25 per cent. When buying a home, you should ideally keep aside three months of funds (including EMIs and expenses) as a back-up.
Says Gaurav Mashruwala, Certified Financial Planner, ACE Financial Advisory Services: “Do your own personal net worth calculation to keep track of your financial standing. This can be obtained by dividing the sum of all your assets such as money in savings or current account, NSCs, EPFs, property value, car value, stock value, etc., with total debts such as home mortgage, credit card balance, etc. Your total principal liabilities should not be more than 50 per cent of your assets.”
According to Mashruwala, overleveraging is a high-risk, low-return game. When you borrow for investment purposes, your net income depends on the returns generated from that asset class minus the interest paid. For example, X and Y invest Rs 5,000 each in a stock. While X invests his own money, Y borrows the same amount at the rate of 10 per cent annum. Let’s assume that over the next three years, the stock generates returns of 40 per cent. After three years, the net income for X will be Rs 7,000 – Rs 5,000 = Rs 2,000, but for Y, it will be Rs 7,000 – Rs 6,500 = Rs 500. Agrees Amar Pandit, Director, My Financial Advisor: “Borrowing to invest is a strict no-no.”
Watch your spending
Eliminating unnecessary expenses and saving prudently are the keys to sound financial health. To illustrate the virtues of saving, if you save an additional Rs 5,000 every month and invest it in a debt instrument that gives 8 per cent annual returns, it will grow to over Rs 17.5 lakh in 15 years. Says Pandit: “To reduce expenses, one can keep a check on entertainment expenses, cut down on the extra phone and look for bargains and offers while shopping.” Other ways of cutting expenses and increase savings are keeping interest payments on credit cards to the minimum, and even scaling up one’s income.
Regular saving and investing makes all the difference between hitting and missing financial goals. Says Himanshu Kohli, Founder Partner, Client Associates: “Every investor should balance wealth creators (equity and real-estate) and wealth preservers (debt) in line with his financial profile, investment objectives, risk appetite and time horizon. Try to put your money in investments that can earn you higher returns than the rate at which you are borrowing. This will help generate positive cash flows for you while servicing your loan.” You will be better off if you have emergency funds the size of 3-6 months of your monthly expenses to deal with unforeseen contingencies. Last, but not the least, buy mediclaim, accidental insurance, permanent disability and professional indemnity policies.