To Pre-pay or not…….Make your choice

I have been writing posts which shall eventually lead to a broader discussion on financial literacy and the approach to take to manage one’s finances.

In my last post, I had reasoned that everything boils down to a simple equation (Incomes less Expenses = Resultant surplus). One of the uses that this surplus can be put to is the pre-payment of past loans taken.

I thought it might help if there is further discussion on this, exploring different perspectives.

There are two divergent approaches towards personal debt. Thereafter, there are many factors which influence our decision when to pre-pay an outstanding loan.

Classical economics:

This theory believes that we should never pre-pay loans.

India is in a growth phase (never mind a temporary blip) and a necessary by-product of this is inflation. With continuous inflation over a period (assumed to moderate and high in phases), the value of the rupee will keep falling over the life of a loan. You therefore end up paying back the loan with a cheaper rupee. The value of the rupee continuously erodes over this period due to inflation.

Let us look what inflation has done to the rupee in the last five years. At an average inflation of 6.5% in the last five years, the value of a rupee has fallen 27%. Rs. 100/- (in 2004) is now worth Rs. 73 only. Conversely, due to inflation, you would need Rs. 138/- to buy what cost us only Rs, 100/- in 2004. As the rupee becomes cheaper due to inflation, the burden of repaying debt will progressively reduce.

Traditional economics:

This theory belongs to that school of thought which believes that loans are an unnecessary burden and if we have surplus cash which has no immediate use, then you must utilize it to prepay outstanding loans and reduce your indebtedness.

The rationale is to be debt free and not to live on borrowed money.

Let me now discuss some of the factors that we take into account whilst taking a decision to prepay a loan.

Income Tax incentives.

Our Income Tax rules allow us to pay lower tax if we have a housing loan outstanding. The amount of interest that we pay on our loan can be reduced from our total income for calculation of our tax liability. This results in our income tax being lower.

For every Rs. 100/- paid as interest, we save income tax of Rs. 33.99. The net interest that we actually end up paying is Rs. 66.01. Logically this should be an incentive not to pre-pay the loan.

Surplus cash flows

The borrower may, a few years down the road, have surplus cash flows. This may happen due to increase in income levels, large receipts as bonus, incentives, large business deals / orders, lucrative assignments or gifts / legacy receipts.

The idea is if alternative investment options do not give return more the interest we pay (as in the current scenario), it makes ample sense to pre-pay the loan out of the surplus that we have. If the surplus is not significant, it makes sense to continue with the loan. Remember the old maxim (modified slightly) – A penny in liability reduced is a penny earned.

This will result in reduction in liability and increase in money-at-hand.

The second factor seems to contradict the rationale of utilizing tax incentives. There is some point at which tax incentives stop being material. If you look at that point closely, you have to spend Rs. 100/- to get a tax incentive of Rs.33.99. The day we start asking the question – Why don’t I pay Rs.33.99 and have surplus cash of Rs. 66.01 in hand, we must start prepaying our loans.

From the above arguments, there is no standard solution applicable to every borrower. Each situation is unique and has to be dealt with accordingly. Other factors like, levels of income, flow and sustainability of incomes, impact of commitments in terms of expenses apply and the decision could be not to prepay.

If you were to turn around and ask me what would I do? – I would probably prepay a fifteen year loan within seven – eight years and free my cash flows. Free cash flow also gives me flexibility and the ability to grab good opportunities that may present themselves from time to time. I must also confess that I am a bit of a traditionalist at heart.

Our focus - Incomes less Expenses

This magic equation never fails. This is the ultimate truth of our financial well being

Incomes less Expenses = Resultant Surplus.

At the end any surplus money that we have in hand is always the result of our incomes exceeding our expenses. Some may say that they do have money in hand but that comes from borrowing. This series of posts have not taken “borrowings” as a means of cash inflow. I have stuck to “conventional wisdom” or a “conservative approach” if you will.

These resultant surpluses do not automatically become savings. These have to be managed for them to become savings. A person or family having a surplus could

- Save and invest, or

- Spend the surplus away on consumption, or

- Use this for asset acquisition, or

- Prepay debts taken earlier for any purpose.

Each person / family would, presumably, choose any of the above options in their best interest and depending on their financial position. I am referring to option -2 above. It is not necessarily irrational to choose spending especially if surpluses have been adequately put aside and built-up in the past.

We eventually need to build our understanding on how to manage our surpluses. This is in essence the core of “Financial Literacy”.

A note on borrowings:

Easy borrowings to facilitate spending, fortunately has not been a part of the larger Indian psyche. It did make its presence felt mainly in urban areas and amongst youth but thankfully has been a restricted phenomenon. The growth rates in “loan products” has seen a phenomenal rise in the past decade or so but the absolute figures still seem in control.

Borrowings, however, have been accepted as a norm to finance asset acquisitions like buying a house or car or some other assets. The best part is such borrowings never run their full course. People tend to pre-pay their loans and be debt-free. A normal fifteen year home loan has an average life of just seven – eight years.

This shows the general aversion of an average Indian to carry debt in his name and a sense of shame attached to inability to repay or repossession of the asset acquired out of that debt.

I also think, the spectre of slowdown, job losses and loss of confidence in sustainability of one’s income flow has in the recent past slammed the brakes hard on free spending. One can sense a general tightening of belts and postponing non-essential expenditure.

Some interesting links for those interested in further reading:

1. http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4105
2. http://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=198
3. http://www.mydigitalfc.com/personal-finance/indian-consumers-turn-debt-averse-survey-595

We shall examine the basic principles of money management and how our surplus money may be handled.

”Expenses”……Further Insight

We have seen that expenses are continuous and irrespective of our incomes tend to be more or less fixed unless some event acts to “shut the tap” so to say.

Why do people spend their money the way they do? This is a fascinating subject of study for all behavioural scientists and more recently to all followers of “Behavioural Finance” too. Is there a link between our spending habits and our mental make-up? Whilst the new sciences do believe that there is a definite and deep link, many rationalists would pooh-pooh this. Their theories are based on a presumption that a human being is a rational person and all financial decisions taken are rational and in their own considered self interest.

Do we see this playing out so simply in real life?

I had shared my observations in the previous posts about how one’s upbringing, amongst other factors, influenced the approach and attitudes of people. This and its link to their financial position or more specifically to income earning capabilities are widely seen.

Similarly, one’s unique conditions in life and upbringing, education, values, amongst others, influences how one handles money earned and spends it. Other factors that deeply impact our spending are those relating to family. Large/ smaller joint family units impact in different ways. Independent nuclear units may have more moderate expense budgets whilst those with elders would necessarily mean larger outlays.

A modest background in childhood may manifest into a moderate expense outlay later. Yet, another family with a similar background may develop a need to spend much higher so as to be seen as prosperous or “accepted” if you will, in their peer group. At the same time a wealthy family may live simply and not feel the need to spend beyond their requirements.

To cite some examples (I have tried to eliminate subjectivity to the extent possible). A double income family believes that eating outside every weekend is a good way to spend quality time with the kids and gives every one a break and a change. Yet another family would eat at home believing that was the best way things were done.

Result : Expense levels are different.

Another example – a family subscribes to one English daily newspaper and a couple of magazines. Another requires two English dailies, one business daily, a regional language newspaper and a few magazines, one of which is an international magazine.Result: Expense levels are different.

Let us take an example of asset acquisition. One family with staying in their family home or a house that has been a legacy/gift is on a different level, whereas, another family with similar income levels may need to take on loan commitments to acquire a house for themselves. Result: Outflows may be different affecting the surplus in hand.

Why are there such differences?

This is tricky and definitely more complex. You will see here that apart from levels of income, many personal and social factors leave their influence and contribute to unique spending habits. It is not the objective of this post to analyse any type of behaviour and pass judgment on the desirability or otherwise of such behaviour.

Our study is to understand that at the end of the day, Incomes and Expenses eventually determine the quantum of surplus that one has at hand. Our effort to increase financial literacy is directed towards understanding how this resultant surplus may be handled. It is, however, important to understand some of the many factors influencing financial position. This helps the person or his/her advisor get a proper perspective whilst reviewing their financial health card and in their planning exercise.

If you reflect on this, you will realize that smart marketing and product positioning is a way to exploit these vagaries of the human mind and get a person to spend. This is, however, the subject matter of another post.

We take this forward examining how this resultant surplus may be handled.

The Second Aspect of our Financial Health Card

We have seen how Incomes and Capacity to earn are influenced by a host of many factors, including our upbringing, attitudes and the like.

In this post I will discuss about the outflow of money on account of expenses.

Whilst Incomes are largely steady and fixed for those employed and lumpy and at uncertain intervals for the non-employed category, expenses without exception are regular month on month with spikes large or small.

It is an eternal truth that money has a velocity and flows in a cycle continuously changing hands. The flow is inevitable, only the velocity keeps changing.

This flow of money in the economic system broadly represents income for the recipient and expense for the spender.

Incurring an expense is the act of spending money to get goods, services or satisfaction in return. Let us delve a little deeper in this. Expenses (including expenditure for the technical minded) can be divided as follows

Normal living expenses

These are the day-to-day expenses that are necessary for living in the current day and age. These would cover expenses on food, clothes, rents and taxes, electricity, conveyance, education, health, communication, information.

Such expenses are relatively inflexible and we have to incur them in order to live (more dramatically – survive). Even here where we presume relative inflexibility, we find that depending on income levels and propensity to spend, expense levels will vary across different strata of society.

Asset acquisition

It is always a dream to have one’s own house and in India, this is a great life time project. I will classify house buying as key asset acquisition expenditure.

Discretionary

These are expenses on goods and services which are not in the “Must Have” category. They can be classified as “Nice to Have”.

Let me try and give an illustration…….A foreign vacation is a discretionary expense to one while a visit to a movie at a multiplex could be a painful (and therefore discretionary expense) decision for another.

Simply put, these are expenses which may be postponed if you choose not to incur them. One has to think before committing to these expenses.

Emergency

These are normally associated with health problems, accidents, sudden unexpected events (travel on account of death of a near and dear one) and therefore unplanned and unforeseen.

If you observe closely, three of the above are not water tight silos and expenses are not rigidly classified under each.

Depending on the level of income and other factors many expenses will move from being Normal Living expenses, Asset Acquisitions and Discretionary. I presume that food and other survival expenses will never be classified as a discretionary expense. However, to a family which has “Chapatis” for breakfast, the decision to have corn flakes will become discretionary.

Similarly, buying a car may be a normal living expense to a professional/businessman earning say Rs.50.00 lakhs per year, asset acquisition to an executive earning Rs. 15.00 lakhs and discretionary to one earning Rs. 5.00 lakh per year.

In this post, I have explored the basic nature of “Expense” and attempted a broad classification. My next post will take this further and examine “Expense” further from a different perspective.

A Closer Look at Some Factors Influencing Our Financial Position

The previous post examined how Income was a result of choices made and how a person shaped up in life. It is amazing to see how our family background and our upbringing impact our attitudes and approach in later life and how this eventually links up with capacity to earn.

Let me share some of my observations here. These are not judgments or a discussion on what is right? Or what is wrong? This is an attempt to highlight some of the influencing factors.

Let me discuss one case (names, places and time not considered relevant for our discussion) in our neighbourhood that I had a ring side view for over two decades and made me ponder on what shapes financial position in later life.

This is an instance of two families with similar financial and educational background, working in very similar jobs with single earning members and staying in typical one bedroom (1BHK) apartments. A typical middle class family that one sees all over.

Children of both families attend the same school with reasonable above average intelligence. Nothing out of the ordinary here and logically the future should largely be parallel.

What happens is something like this….The child from one family goes to qualify as a brilliant doctor with top rankings and the younger child goes to be a brilliant industrial designer. Opportunities abound and monetary position is on a distinctly higher level.

In the second family, one child completes graduation and gets a job in a bank. whilst the younger becomes an engineer and gets a job in a medium sized engineering firm. Incomes are on a slightly lower level.

Let me clarify here – I am not getting into a discussion on luck, destiny or any such matter. This close observation of over two decades helped me trace many differences between these two families and I believe they have played a major role in shaping up attitudes of these children, their approach to problems, their enthusiasm, passion for anything in life, their tenacity …..infact their intellectual and emotional quotient was different.

Some of the factors have been - emphasis on education, family discipline, bonding, reading habits, outlook and attitude of parents, responses to difficult times, social networking, manners and social etiquette….etc.

I was amazed at why all these play a role in shaping our financial position, amongst others, in later life. I almost dismissed this as a one-of co-relation but then as I got deeper in the financial markets, I got an opportunity to interact with innumerable people and found that my earlier observations were not random. This kept coming back quite regularly till I was convinced that my observation were indeed not a flight of fancy.

This does not suggest in any way that we are powerless to better our lot. In fact, hard work, smart work, enthusiasm and passion are a must that need be inculcated in every child and it is our birth right to aspire for betterment in our lives and we have seen numerous instances when this has happened. Some of us will probably vouch that this has been their personal experience.

I urge readers of this post not to start an analysis of their own lives and imagine shortcomings where none existed in the first place. There is nothing right or wrong about this just as there is no agreement on How much money is enough?

In my next post, I will look at Expenses – the second aspect of the financial literacy puzzle.

Moving Ahead – Income, The First Step in our Journey

In my last post on Financial Literacy, I had talked about the whole game having three sides to it.

Let us, in this post, examine the first i.e., the income side.

All our efforts in life are to earn adequate income and more. Many of us opt for a job and work out a career plan thereon. Others with a family business would probably take this opportunity that already exists. There are many others who have been bitten by entrepreneurial bug and want to strike out on their own – the first generation entrepreneur.

It is also possible that later in life some would cross over from the comforts of a job to the wild thrills of striking out on their own and at the same time many will want to switch to a job after a few years of doing their own thing.

Whatever the choice made, it is the result of various influences in a person’s life, the past and current circumstances existing in that person’s life, upbringing, family background and such other intangibles.

Depending on the choice made and, how the person shapes up later in life will determine the level and flow of income. It logically follows that this will vary from person to person and keeps changing at different points of time in a person’s life.

At this stage it will be useful to examine “Income” in the light of the following factors:

• Age of the income earner,
• Quantum of total income in a period – say a year,
• Quantum of income at shorter intervals – say every month – whether fixed or fluctuating amounts,
• Regularity of income – Whether at regular intervals or are they random inflows,
• Possibility of increase in Income in future or decrease (in bad times) or what happens if it stops (due to death, disablement or retirement) or whether it remains flattish,
• Vulnerability of income to changing circumstances – These may be economic or from obsolescence of one’s skills or it could be for any personal reasons - health. E.g., Due to growth of supermarkets, smaller grocery shops could face squeeze in profit margins and incomes of that businessman may be threatened by competition. (There will be many similar or different live examples).

Everyday, we see differences between people. Incomes vary, levels of wealth vary, capabilities of earning are different, attitudes are different and a host of other things.

Let me now go back to my earlier post and highlight a point made then, which is very relevant here.

“Under each of these heads lie all the complex variables that interplay with each other and make each person’s financial situation as unique as it can be.”

I have attempted to list just a few variables that impact a person’s life in general and its effect on the monetary situation. In the next post, I will attempt to study “Income” from another perspective.

Financial Literacy - A Quick Recap

I had raised this issue of Financial Illiteracy in my post “Financial Illiteracy – An unaffordable Luxury” on 25^th October 2008 and then followed in up with “The First Step towards Financial Literacy” on 2^nd November 2008.

This was till we got seriously derailed by dramatic events of 26/11 and thereafter.

I think it is time we get back on track and bridge this wide gap of over two months.

Let me recap on what I have covered so far.

In the first post “Financial Illiteracy – An Unaffordable Luxury”

Money is empowering and liberating and we put such immense effort to acquire more money in our lives. This process begins right from childhood and we spend time training ourselves to earn an then earning money. We then reach a sort of dead end as we are utterly incapable of managing this money. Much of this is due to our “Financial Illiteracy”

With passage of time those yesteryears seem so simple and golden. There were few choices and Financial Planning seemed an unnecessary luxury.

However, with changing times, there has been a trade-off and we now have choice, sophistication, advice, facilities, information, ease of transaction at the cost of risk, volatility, uncertainty and complexity.

It is, therefore very critical, that we are equipped to navigate through this maze and understand the basic concepts.

In the second post “The First Step towards Financial Literacy”, I looked at

Our financial position is not to viewed in isolation but is a byproduct of how we live our lives and our attitudes, values and upbringing. Once basics are understood, further build-up are

The whole game has three dimensions

Incomes and capacity to earn

Expenses, and

Resultant surpluses which becomes our retained wealth and available for investments and management.

These three dimensions cover the complex variables that inter-twine to influence our lives. It is important to also remember that each person / family is unique and has a different requirement. There is no standardized “One size fits all” solution here.

This recap brings us back into focus. The next post talks about the first dimension – Incomes.

The First Step towards Financial Literacy

My attempt is not to study “managing one’s finances” in isolation as a very narrow topic. I believe our financial health card, so to say is a by product of how we live our life itself. Once we understand the basics, the build-up is very logical and simple – completely de-mystified.

Our times are changing fast and bringing in its wake unheard of opportunities. This has meant widening employment and entrepreneurial opportunities and higher incomes. Often, high incomes come at a young age when responsibilities are not many.

As I had mentioned in an earlier post that having money is empowering, it presumes that flow of income is constant and abundant enough to leave a surplus after needs are taken care of. Further, our attitudes, our background and our upbringing plays a major role in shaping our approach to handling money.

Whilst every body would like to be a “crorepati” (a “lakhpati” has no value today) today or at some date in future, it is possible that many may not reach their target, while a few may achieve it many times over. It is also entirely possible that with inflation, a sum of Rs. one crore then may be very ordinary and bar has moved higher.

Let me try and put things in a simpler perspective.

This whole game has three sides to it

- Incomes earned or capacity to earn,

- Expenses – both living and discretionary,

- Resultant Surpluses and its subsequent investment and management.

Under each of these heads lie all the complex variables that interplay with each other and make each person’s financial situation as unique as it can be. This is a very important basic principle that we must keep in mind but do not.

Each one of us is unique and this impacts our financial condition. It follows logically that each requirement is unique and therefore has a separate solution. What works for one, need not (Please note my emphasis) work for the other. We will see at a later stage, especially, in the context of stock market investments, how this has played havoc with people.

I would like to examine all variables that fall under these three heads mentioned above and the impact it has on one’s financial health card. This will help us understand the basics better and, hopefully, stop being awed by a lot of jargon and smart marketing.

Financial Illiteracy – An Unaffordable Luxury

MONEY is the eternal elixir of life. It is power. It is energy. It is a passport to conveniences of life. It is the most powerful antidote to the crippling constraints imposed by poverty. Money is empowering and yes an obsession with money also brings in its wake misery – but that is besides the point here.

It is a fact that people spend the maximum time, first training themselves to earn and then earning money. The amount of effort put in getting good education and then getting a good paying job is almost Himalayan in dimension.

This is not the end of it. Once having entered in that never ending spiral, the person is completely pre-occupied in efforts to increase his/her income. This is normally done by working harder, working longer hours, opting for higher and specialized education and so on. The spiral continues and we are sucked deeper into it trying to earn more money.

The question that now arises is - How should one manage this money?

Isn’t is funny that so much effort is put in, time and resources invested to develop a high earning capacity but people are totally ignorant about how this money should be managed.

I call this “Financial Illiteracy”.

Life was simpler in the past. The choice was limited and one would place money in nationalized bank fixed deposits or small savings schemes managed by the Post Office or the popular Public Provident Fund. Of course, there was the mandatory insurance with Life Insurance Corporation (LIC) and units of UTI where you had almost assured dividends every year.

Stock markets were considered as “gambling dens” and avoided by a large section of the population.

Times have since changed. Many changes have taken place and India is slowly moving away from a tightly controlled and Government owned structure to a more market related structure.

This has meant

- Exposure to market fluctuations
- High fixed returns now becoming a thing of past
- Safety has become relative and capital is exposed to possibility of loss
- Element of risk is now an important factor to be taken into consideration
- Entry of private players in the financial markets
- There are now multiple choices and of varying complexity
- Smart marketing and product positioning has come to stay
- “Financial Advisors” is a new breed that will be part of the scene henceforth.
- Introduction of dematerialization has added a new concept of ownership.


It has now become imperative to understand how to navigate through this maze. It has become increasingly important that basic concepts are understood such that one is not taken for a ride. It has also become necessary to understand financial and other types of risk and accept it as a part of our life.

It shall be my endeavour to expand on this theme and attempt to de-mystify some of the so-called complexities.